[TEJ Finance Research Institute] Default Risk and Liquidity Risk of China Evergrande Group
Evergrande Group’s financial situation from the perspectives of CCRQM’s Unlisted Companies Rating System
🔸 Preface 🔸
The global economy was hit to some extent in 2020 during the pandemic. As we move into 2021, most countries around the world are shifting to measures that people should adopt co-existence with Covid-19 virus as vaccination rate increases. Their economies are gradually recovering on track. The seemingly thriving global financial markets have been hit by the announcement of China Evergrande’s “being insolvent to repay its debts as they fall due” event.
This wave exacerbates the fragility of Chinese economic environments. On October 4, Hong Kong Stock Exchange announced that trading in China Evergrande Group (3333.HK) would be suspended immediately since that point, and as the stock price plummeted and trading was suspended, the company still had an astronomical figure of debt valued at RMB1.95 trillion to repay as scheduled. Will this seemingly ‘too big to fail’ enterprise be supported by the government and survive to reach pinnacle again?
✨ Analysis into recent events — Liquidity Crisis, Insolvent Debt, Credit Downgrade ✨
- Event trigger — Chinese government enforces three tough regulatory measures
In 1996, Hsu Chia Yin founded Evergrande Group in Guangzhou, and its core business is real estate development. Evergrande Group extends across new-energy vehicles, tourism, sports, finance, health care, and other diversified businesses. In the sales of real estate, Evergrande has its own sets of profit model, first financing the purchase of land and then pledging the land for cash to reinvest in the purchase of new lands. For the sales part, Evergrande offers prices that are higher than the average of the housing market in the same area and then releases large sales promotions to provoke consumers’ desire. The Evergrande Group has achieved brilliant records with this set of models. For example, the houses were sold out within two hours of the opening, and hundreds of millions of cash flow can be received in one single morning. Careful readers would find out that to achieve such a highly leveraged operation, the most important part is the liquidity of financing, but the discussion of the liquidity issues lies in whether the company’s cash flow can repay the installment of land purchases. In August 2020, the Ministry of Housing and Urban-Rural Development and the People’s Bank of China (China’s central bank) jointly introduced three regulatory requirements for property developers to comply with, which will undoubtedly cut off the capital expansion that most property groups in China rely on for operation. How many property groups will collapse behind the heightened regulation?
Here are the details of three regulatory requirements
1.Debt Asset ratio, excluding prepaid expenses, must be less than 70%
2.Net debt ratio must not be greater than 100%
3.Cash to short term debt ratio must not be less than the double
- Evergrande attempts to restore restricted liquidity
If a real estate enterprise violates any one of these rules, the annual debt growth rate shall not exceed 10%; if it violates two rules, it shall not exceed 5%; if it violates all three rules, it shall not create new interest-bearing debts, and non-defaulting real estate enterprises would only be able to increase their financing liabilities by 15% at most. However, Evergrande Group violated all three items at the time of the announcement, which means that Evergrande Group was not allowed to create new interest-bearing debt and could not carry out compliant financing through banks. This increased the liquidity risk and credit risk associated with Evergrande’s highly leveraged financial operations. In order to solve the fundraising problem and try to resume interest-bearing debt loans, the Evergrande Group boosted its housing sales promotions, sold the housing assets it owns, and continuously sought to expand its capital inflow channels by issuing high-yield financial products through its subsidiary, Evergrande Wealth company. By increasing the bonus commission rate, the salesmen were more willing to fully concentrate on selling new financial products to earn high commissions. Meanwhile, Evergrande convinced the company’s internal staff to invest in deposits, increasing the ranges of financial products and lowering the price of home sales contracts to increase cash inflows in an attempt to alleviate the liquidity crisis.
- Liquidity crisis emerges without warning signs
On 31 May 2021, China Evergrande released a promotion offer — 531 House Purchase Festival. During the period, consumers were able to purchase a furnished home at a 25% discount and were required to pay in full within half a month, and were promised to deliver their houses between 2023 and 2025. Many consumers are unaware of internal information, thinking that it is lucrative to purchase houses in huge amounts of cash that they own. On 14 September of the same year, China Evergrande Group officially announced, “Two subsidiaries of the Group failed to fulfill the guarantee obligations provided by third-party wealth management products as scheduled, and the related amount was approximately RMB 934 million. The Company is actively negotiating with the issuers and investors so as to reach a consensus for repayment arrangement. This announcement is almost equal to the verdict which implies that China’s housing boom has officially entered a restructuring phase.
According to Moody’s Column of China Real Estate Industry “ FOCUS — China Real Estate Market: Sales Growth Lending to Put Liquidity Pressure on Developers”, the number of bond issuances by Chinese real estate companies in July and August decreased significantly compared to the monthly average in 2020. The table is shown below. Therefore, we can realize that access to external financing declined significantly after the relevant regulations were enforced. Being inaccessible to raise funds directly resulted in the announcement of the inability to repay debt in September.
✨High local credit rating in China, downgrade substantially, fast and furious✨
On 12 April this year, Evergrande Group issued 21 Evergrande 01(21恒大01) to raise RMB8.2 billion from the market. At that time, the local credit rating agency in China rated the unsecured bond as 3A (the best). In the middle of the year, rumor has it that Evergrande is going to default causing a liquidity crisis in the market. However, on the one hand, Evergrande continued to dispel the rumors to its investors. On the other hand, the person in charge was interviewed by the Chinese authorities.
On 2 September 2021, the credit rating of Evergrande Group was downgraded to “AA” and placed on the Continuous Downgrade Watch List by China Chengxin Credit Rating Group. On the 14th of the same month after the downgrade, there was an outbreak of illiquidity defaults. On the next day (15th), the rating was downgraded again to ‘A’.
Two consecutive downgrades within just two weeks, from the highest rating of “AAA” to “A”, but it is true that the company has defaulted on its obligations and has left investors skeptical “Are A-rated companies so prone to default?”
It is difficult for investors to ascertain the level of credit risk faced by companies through China credit rating reports. The information is under-disclosed and unreliable, but TEJ has heard your voice and realized your concerns. We offer the CCRQM corporate risk model, which includes not only listed companies but also unlisted companies in China or companies listed in Hong Kong, and therefore users can use the complete information to reveal the risks faced by companies with confidence.
✨What is CCRQM? ✨
TEJ has been established for more than 30 years. It has been committed to database building and delivering enterprise solutions for a long time, making it the largest financial information provider in Taiwan. In addition, we provide Chinese enterprise information for many years and provide online analysis tools for use. It is easy to measure the level of risk of Chinese enterprises. Most Chinese companies have opaque information and inflated bond ratings. It has always been the biggest problem we face when investing in Chinese companies. Since 2013, TEJ released the China Corporate Credit Quantitative Model, CCRQM, for testing Chinese corporate credit risk, which is a rating tool we designed specifically for judging Chinese corporate credit risk. TEJ uses the financial data from financial reports to create logistic regression and expert judgment to decide the best combination of variables and variable weights in models. In this way, the credit scoring model of the scorecard generates user-friendly credit scores. CCRQM divides the rated companies into 10 grades. With grades 1–4 as low risk and investment grade, such enterprises have the characteristics of profitability, financial stability, high liquidity, and stable operation rights in the main business. With grades 5–6 is moderate risk and still belongs to investment grade. This type of company has a stable structure but poor profit or a good profit but poor corporate structure, and its resistance to economic impact is worse than that of the top four grades companies. With grades 7–9 as high risk but high-yield level. Such enterprises have the characteristics of unstable operating rights, continuous lack of main business, accumulated losses for many years, flat profit and loss but poor accounting quality or flat profit and loss but extremely poor liquidity. Finally, the D grade belongs to the occurrence of default affairs companies.
The credit crisis that erupted by the Evergrande Group seems to be impossible to track, but there are traces to follow. Since 2016, TEJ has shown that Evergrande Group has been listed as a high-risk level company through the CCRQM unlisted scoring system risk rating for four consecutive years. In 2020, the CCRQM tool had shown that Evergrande Group’s risk level has been raised to level 8. It is recommended that investors must carefully assess risks before investing.
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