The news of China’s Evergrande group on the brink of default halted the euphoric markets for a day or two in the past week. Amidst conflicting news of a possible deal, markets forgot the situation is far from over and scaled new heights. With over $300 billion in debt, the largest construction company in China is still facing a severe cash crunch as it struggles to raise cash for coming coupon payments by selling its assets and has missed payments for overseas investors.
The situation is not ordinary because when a market leader is facing a crisis, it says a lot about the sector’s pulse in general. The construction sector in China accounts for roughly 25% of the economy (if we account for both direct and indirect linkages). Thus, any major bankruptcy in the top-10 league is sure to trickle down, with cascading effects on the other sectors, including exports to China.
The construction sector has been a mainstay of Chinese growth for a very long time. With massive urbanisation, the industry employed rural Chinese labour, thus creating enormous purchasing power for goods produced by other sectors. Structurally, the industry has a high pull effect. For the period 2001-15, the pull effect of different sectors on the construction industry began to exceed the push effect of the construction industry on other industries after 2006. This gap increased significantly in 2013, which makes the current situation a cause of worry.
By 2016, commentators in China concluded that the economy was entering a new normal with traditional sectors such as construction, low-end manufacturing unable to contribute to high growth. Under the influence of restructuring towards consumption and pushing for a new knowledge-driven industry, the sector is already slowing. Interestingly, Chinese scholars concluded, as far back as 2016, that investment in the traditional sector and that in the new industry show a strong substitution pattern.
The reasoning finds substantial basis in Evergrande group investment strategy with core construction company ploughing its profits in knowledge economy sectors by venturing into electric vehicles, online streaming media operation, health management, among others. Some of these ventures also directly relate to the belt and road initiative (BRI) of China. With the ongoing crackdown in knowledge economy sectors and power shortage in China, the realisable value of some Evergrande group subsidiaries needs to be watched out for.
The impact of COVID-19 is also not a comforting factor for the construction sector. The residential property prices have sharply corrected since 2020 and are yet to regain pre-COVID levels.
What will be the impact of large-scale bankruptcy in construction sectors in China? Well, bankruptcy or restructuring is akin to the loss of output or supply. A static stimulation for 10% loss of output in construction is shown in the chart below:
How will the problem develop, going forward? Well, a lot depends upon how the constructions company under stress use the Chinese bankruptcy laws and what makes sense – reorganisation vs liquidation vs voluntary bankruptcy.
Not much is known about how bankruptcy procedures operate in China. The recent study by Bo Li and Jacopo Ponticelli only throws some light on this very recent but significant development inside China. Their sample between the period 2011-20 shows that liquidation is the general rule.
Further, for the huge company, i.e., employees more than 5,000 forming a very small share in the sample. The construction sector underwent 565 bankruptcies accounting for 20% of total cases between 2011-20.
The average time for resolution of cases under new law through special courts has decreased by around 500-odd days. However, the median turnover time for construction and real estate companies is one of the highest 520 days.
Further the study does not throw much light on the status of operational creditors such as the home-buyer in the construction sector, a point which CPCs will not ignore. The average recovery rate for the ordinary unsecured creditor is only 13.3% in their study, indicating that large-scale bankruptcy may trigger joint defaults in other sectors, which are operational creditors to the constructions sector.
In all, the evolving situation in the construction sector warrants close monitoring. In particular global funds investing in China and some of the Indian fund-of-funds may be in for a surprise.
If we segregate the construction into – construction of buildings (62% of the sector), civil engineering (23%) and specialised construction (15%), the first category is where the current crisis will impact the most.
That leaves the second and the third category to keep the demand going. With the recent natural calamity in China, civil projects may see some activity, but specialised construction of domestic and project exports under BRI will have a mixed trend.
Thus, even if the bankruptcy laws ensure an orderly resolution, the cost of loss of output and demand will take time to recover. The situation will compound further as the power shortage disrupts both traditional and new sectors of the economy.
From an Indian point of view, while the market regulator has allowed the mutual funds to invest in overseas assets up to a limit, it is difficult to calculate the exact country-wise exposure of resident Indian investors.
The most recent data from the Reserve Bank of India (RBI) on foreign liabilities and assets of mutual fund (MF) companies shows that foreign assets of MF companies increased due to rise in equity security and other foreign assets during the year and stood at $2.9 billion at end-March 2021.
But the most surprising part is the Indian investor and the mutual funds are bullish on their China funds when China is taking an aggressive posture against India. Further, Indians are quite naïvely funding the very technology that will kill India’s information technology (IT) and business process outsourcing (BPO) industry in the coming years.
In a nutshell, if the current situation in China gets worse, Indian markets may see sharp correction; not to mention that internal turmoil may precipitate more aggressive external response to divert attention.
(The author is an economist in the banking system. The views are personal)
