The Chinese government has faced several tests of its economic mettle in recent years. Each time investors could be sure of a muscular response, from the unleashing of credit booms to heavy intervention in financial markets. 

But Beijing’s lack of support for Evergrande, the country’s largest real estate developer, is upending such expectations. The heavily-indebted company last week failed to make a scheduled $83.5 million interest payment on one of its $20 billion worth of dollar-denominated bonds. 

The shock for investors, particularly those overseas, has been profound. Many had piled into dollar bonds issued by Evergrande and other Chinese property developers, partly for their attractive returns. Bondholders also assumed Beijing would intervene and bail out the company if its debts became unsustainable. 

“Sheer panic” says Stephen Jen, chief executive and co-founder of asset management firm Eurizon SLJ Capital, when describing the market reaction outside China to Evergrande’s fall. He says that foreign investors desperate for good returns had rushed indiscriminately into Chinese high-yield bonds, noting that “they weren’t too picky about who was issuing the debt.”

Another crucial factor those foreign investors seem to have missed: Evergrande is a victim of Beijing’s own policy actions, beginning with strict curbs placed on the country’s real estate developers aimed at taming their debt-fueled expansion last autumn.

In the past year, Beijing’s regulatory assault on tech giants like Alibaba and Meituan, as well as the online education sector, suggest a new approach to dealing with businesses and the markets. The authorities now seem prepared to risk short-term economic harm in pursuit of its broader policy objectives, such as narrowing the country’s wealth gap and making homes more affordable.

“Beijing is increasingly waging a campaign against the private sector firms, and is no longer so concerned about the impact,” says Logan Wright, a director at Rhodium Group who leads its China market research. “The property sector is now in the government’s crosshairs. It is determined to reduce its importance in the overall economy.”

The big change for investors, Wright adds, is that they can no longer plow money into risky Chinese assets with the confidence that Beijing would step in at times of stress. “This is a moment of reform,” he says.

The Chinese authorities’ apparent unwillingness to support Evergrande begs another question: How did they allow the country’s largest developer to reach the brink of collapse? Evergrande’s perilous position was no secret: Its liabilities have grown to over $300 billion, equivalent to about 2 percent of China’s annual GDP.

The answer lies in real estate’s long-time importance to China’s economy. The industry and related services account for around 29 percent of Chinese GDP, according to Kenneth Rogoff of Harvard University and Yuanchen Yang of Tsinghua University, and support millions of jobs (the figure in the U.S. is closer to 17 percent). Beijing has often made strenuous efforts to support the property market: during the last major downturn in the mid-2010s, the government responded with a “slum redevelopment” program to bolster demand, and loosened restrictions on mortgage lending.

Such initiatives only encouraged developers like Evergrande to keep borrowing to build more. Even when Beijing’s top economic policymakers embarked on a campaign to tame the Chinese economy’s eye-watering debt levels from 2018, developers had an answer. They employed methods such as pre-selling more properties — effectively borrowing cash from householders for homes it had yet to build — and issuing more dollar-denominated debt in so-called ‘offshore’ markets.

“The government may have felt that by borrowing overseas, the developers were bringing money into China, and not exposing domestic Chinese banks,” says Alicia Garcia Herrero, chief economist for Asia Pacific at investment bank Natixis. “They went through markets that didn’t appear to threaten systemic risk for China.”

Aggressive expansion by developers, though, led to an oversupply of homes. The Rhodium Group estimates that the inventory of unsold properties in China could house 30 million families. Such trends may only worsen as China’s population declines in years to come.

Beijing’s attitude towards the property sector hardened last year when it introduced new measures, its so-called ‘Three Red Lines’. Real estate developers in breach of all three debt thresholds would not be allowed to increase their debt. 

Evergrande and other developers’ desire to borrow more in dollars was a warning sign that it was running out of ways to borrow inside China, says Eurizon’s Jen. “Why did foreign investors never ask why developers needed dollar funding when all their business is conducted in renminbi?” he asks.

Analysts say Evergrande, for its part, may have believed that continual expansion would put it in a safer position: The more important it became to China’s property market, the more Beijing would have to support it. Over the years the company, under its well-connected chairman Hui Ka Yan, had expanded into other lines of business, including soccer and electric vehicles.

Yet Evergrande had in fact come to “represent everything the government has been trying to fix about the property market”, says Dinny McMahon, author of China’s Great Wall of Debt. “It is heavily indebted, it is very good at financial engineering to cover up its debts, and has arbitrarily diversified into areas where it has no competence.”

McMahon expects Evergrande to undergo what would effectively be a “bankruptcy without formal proceedings,” with healthier private property companies buying up some of its housing projects and local governments forcing state-owned developers to fork out for its less attractive assets. Few analysts expect Evergrande’s foreign bondholders to be high on the list of creditors to be repaid in full.

Why did foreign investors never ask why developers needed dollar funding when all their business is conducted in renminbi?

Stephen Jen, chief executive and co-founder of asset management firm Eurizon SLJ Capital

Yet even if repairing Evergrande can be achieved in an orderly way, the risk for Beijing is that it may prove unable to contain the knock-on effects. 

“China has a largely state-owned financial system, and Beijing can get local governments, banks and other property developers to share out Evergrande’s assets and especially its liabilities,” says George Magnus, an economist and author of Red Flags: Why Xi’s China is in Jeopardy. “But the consequences for the economy could be pretty significant.” 

Confidence in the property market has already slumped with home sales down 20 percent in August by value. If more developers are unable to borrow they will likely slow construction further. That in turn could harm companies in sectors from steelmaking to consumer durables. 

Rhodium’s Wright points to the fact that developers are likely to stop buying up new land, a vital source of revenue for Chinese local governments. Land sales across 100 major Chinese cities are down by 43 percent already in September. 

Even if few other real estate developers are as indebted as Evergrande, many others are in breach of Beijing’s ‘three red lines’, says Natixis’s Herrero. “I do think it’s a systemic problem,” she says “The whole sector needs to be restructured.”

And while potential home buyers may welcome a fall in house prices — Beijing and Shanghai are two of the world’s most expensive markets, according to Harvard’s Rogoff — a prolonged slump in values would deal a blow to homeowners’ confidence.

In turn, that may hinder another of Beijing’s aims — to try to reorient China’s economy to become more reliant on domestic consumer spending and away from investment and exports.

“There is a sense of risk about all this,” says Herrero, at Natixis. “A lot of what you see is policy makers moving forward because they are about to fall. They feel the cliff behind them and need to run and run.”

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