Written by Daniel Jia.
Image credit: Residential buildings developed by Evergrande in Yuanyang by Windmemories/ Wikimedia Commons, license: CC BY-SA 4.0.
The China opportunity illusion
In late 2021, international investors felt a real chill from China: China’s real estate giant, China Evergrande Group, defaulted on interest payments on US$1.2B offshore bonds. The Evergrande trouble was shocking, but it was only the tip of a monstrous China iceberg, toward which the Titanic of international investors are headed. What would follow in 2023 and beyond? Is Taiwan prepared?
In the past forty years, China has been perceived by countless corporates and individuals as the largest gold mine in modern history: cheap land and raw materials, insatiable appetite for goods, lax regulations, and above all, its favourable policies handed out to foreign investors. As a result, a cumulative $1.6 trillion foreign capital has been poured into China as foreign direct investment (FDI) since the 1980s, when China decided to open up its domestic market to the outside world.
Things started to change gradually in the second half of Trump’s administration. The US-Sino trade war initially triggered this change, then accelerated by the rising tension between China and other major developed countries. In parallel, China’s own economic engines began to lose steam rapidly, and warning sirens started to go off increasingly frequently in its financial sector.
China seems to have transformed itself from a land of success to a minefield overnight. How could that happen? And how would this sudden change affect international investors, including those from Taiwan who have high expectations of enviable investment returns in China?
A case study of the rise and fall of Evergrande might shed light on the real danger for international investors behind the trumpeted China opportunities.
The case of Evergrande drama
A few weeks ago, the suicide of the founder and chairman of Evergrande became big news in China’s internet community.
It would not be a surprise if the “news” turned out to be true. Evergrande, once China’s largest real estate developer by sales volume, has been in a free-fall from grace. Its Hong Kong-listed stock once traded at US$4 at its peak, is now worth less than a dime (as of Dec 9, 2022). Its Chairman Hui Ka Yan’s personal wealth has shrunk from its peak at US$36B in 2019 to US$3B today, according to Forbes’ data. Even this drastically shrunk number is still an overly optimistic estimate for Hui’s remaining fortune, as the government has ordered Hui to use his personal wealth to cover the company’s most urgent debt obligations (e.g. salaries owed to employees, overdue payments to suppliers, domestic loan repayment to financial institutes, etc.).
Hui’s “suicide” turned out to be a show. Hui has used similar tricks to fend off creditors and shore up support from government officials.
Now, international investors ought to be prepared for a harsh reality: the possible loss of entire investments in Evergrande and China’s business entities might soon become an inconvenient consequence of China’s economic downturn.
Evergrande’s US$1.2B offshore debts account for merely one per cent of its total debt liabilities. Its enormous debts, which stood at approximately US$300B equivalent at the end of 2021, are mainly domestic, with only US$20B owed to international investors. To tame Evergrande’s debt beast, the Chinese government has sent a 7-person team to the company to direct its debt restructuring.
The government’s chief goal is to avoid social instabilities stemming from Evergrande’s operational and financial failure. Foreign creditors are not even on the government’s list of concerns because as long as foreign investors still rely on profiting from China’s economy, they would not make a noise, let alone cause a social disturbance. International rating agencies had conveniently chosen to turn a blind eye to Evergrande’s financial troubles, which started to surface long before its December 2021 defaults on offshore bonds. And even if international investment firms want to protect their investors’ rights, there is little they can do other than complain. The Chinese government has habitually been good at ignoring those complaints coming from overseas investors.
Many economic analysts argued that Evergrande is too big to be let fall and that the Chinese government would eventually through it a buoy. But the Chinese government has its hands tied with its own deeds already.
At multiple levels, the Chinese government struggles to make up for the shortfall of revenues after three years of pandemic mismanagement and the consequent nationwide economic idling. But unfortunately, there is simply no spare fund for a private company which has been equally mal-managed and whose final collapse is only a matter of time.
Even if the government did have the financial resources, an Evergrande rescue would encourage hundreds or even thousands of Evergrande-in-the-making to follow suit, i.e., borrow to expand and default to be rescued. Saving Evergrande means the government would be left high and dry in no time.
The only hope for international investors to recuperate their investments in Evergrande (and the like) is to trade in the offshore debts for the company’s stake in its overseas assets, such as its electric vehicle plant and property management arms, as pushed by Evergrande’s debt-restructuring team. But the problem with this solution is that the offshore assets offered are worth only a fraction of the debts owed, even on paper. The real value of these overseas assets could be much smaller. Moreover, as a proof of concept, the EV unit that Evergrande offered to its international creditors as compensation for the defaulted bonds was just shut down due to a lack of viability. Trading one dead investment for another would be of little relief to international investors’ loss other than sowing new disappointments.
Evergrande indicates a much bigger problem
Evergrande is not the only Chinese entity that has defaulted on offshore debts, nor is China’s real estate section the only minefield in which international investors have been trapped.
With Evergrande’s debt perspectives in the background, it would be easier to foresee and understand the fate of the international capital that has been poured into other Chinese entities, which very likely share the same expand-with-borrowed-money growth protocol and defer-until-default debt dealing manual with the fallen Evegrande.
As of early December 2021, when Evergrande was brought under the spotlight after its high-profile defaults on US$1.9B offshore bonds, China’s corporate borrowers had already defaulted on more than US$10B overseas bonds in that year alone, with two-thirds (64%) of the non-repayments coming from firms outside of the red-flagged real estate sector, a 2021 report showed.
If China’s offshore defaults looked bad in 2021, the situation in 2022 is getting much worse and deteriorating at an alarming pace. During the first half of this year, 85% of China’s bond defaults were on overseas debts, as reported by Bloomberg. These offshore defaults are just the sound of a siren announcing the arrival of a tsunami that would wipe out everything that international investors have put into China’s corporates and institutes if China’s economic conditions and relationships with major economies fail to improve.
China’s outstanding offshore bonds stood at approximately US$870B at the beginning of this year, about 80 times of China’s 2021 offshore default tally. In light of the increasing offshore defaults on corporate bonds, the Chinese government urged companies to take necessary measures to “optimize foreign debt structure”. The core of these instructions is “debt rollover,” i.e., replacing the soon-to-be-defaulted debts with new debts. This tactic has been deceitfully deployed in China’s domestic debt market for decades.
Because China’s offshore bonds fall collectively into the junk category when they are issued, there is little incentive for China’s offshore bond issuers to nourish the already rock-bottomed rating by fulfilling their debt obligations once the badly needed money has been raised. Even a pretentious rollover attempt would seem to be a worthless use of time and resources.
These borrow-first default-later corporate attitudes towards offshore debt obligations are bad, but the fundamental drive underneath is much scarier. Chinese government might see those offshore debt obligations as a direct threat to its foreign reserves stability.
Although China has the largest foreign reserves in the world, which stand at a little over US$3T at present, more than half (US$1.6T) of it is from foreign direct investments (FDI), which will need to be paid out when foreign investments decide to leave China, as many are doing recently.
On the other hand, China’s imports need for crucial materials (petroleum, computer chips and data processors, iron ores, animal feeds etc.) to maintain a minimum level of economic activities would cost between US$600B and US$700B annually. Moreover, if the US$870B outstanding offshore corporate debts are to be fully serviced, China would have only US$500B worth of foreign reserves left at its disposal, not even enough to cover ten months of China’s import needs.
With its foreign reserves coffer shrinking due to the slowdown of export activities, offshore debt repayments would definitely be regarded as a waste of foreign reserves.
That is why the Chinese government actively encourages Chinese firms to roll over their overseas debts and probably even quietly encourages defaulting on offshore debts.
International investors should be prepared for the worst outcome from China’s adventures
China’s Evergrande and the like are deploying the defer-and-default tactic on their offshore debt obligations. The Chinese government shrugs off the looming danger of complete investment loss that international creditors face. For overseas investors, the good ole China dream once trumpeted by high return on investment in China projects is now all but broken. The interest-for-capital trap has worked perfectly as intended for China and its corporate subordinates that have been hunting overseas for easy money with sweet promises.
While the international creditors are thrilled to find the too-good-to-be-true high returns for their investment in China, the Chinese government and corporates have already booked the incoming capital as their own fortune.
After this US$870B offshore corporate bonds, China has another US$800B sovereign bonds waiting in line for default.
What do all these mean to investors from Taiwan?
The pretty picture first. Taiwan’s investors have extremely limited exposure to China’s offshore debts, overall notorious corporate debts, or sovereign debts. So, China’s defaults on debts would not have much direct negative impact on Taiwan.
Now the ugly one. Taiwan has allowed its outbound foreign direct investment (FDI) capital to be heavily concentrated in China without sufficient diversification. This could make Taiwan very vulnerable to China economically and politically.
Taiwan is among the largest source nations of China’s inbound FDI, with a cumulative value of US$144 billion as of 2014 and another US$54 billion between 2015 and 2021. Taiwan’s estimated FDI in China accounts for more than one-tenth of China’s outstanding US$1.6 trillion inbound FDI (as of 2017).
Worse still, Taiwan’s FDI has been alarmingly concentrated in China, as compared with three other major sources of China’s FDI (i.e., EU, USA, and Japan). Taiwan’s FDI in China accounted for nearly 60% of its total outbound FDI as of 2014, with the highest level being over 80% in 2010.
The gravest but overlooked danger facing Taiwan’s enormous investment in China is that Taiwan is the only major foreign investor in China without diplomatic status recognized by China and most of the world. This leaves Taiwan’s investment unprotected by international laws should disputes or abuses arise.
The above economic vulnerabilities could make Taiwan’s FDI an easy target of China’s hostage policy, leading to political compromises that would put Taiwan’s national security in danger.
As long as China remains a rogue, totalitarian state, the only safe path for Taiwan’s outbound FDI and Taiwan’s overall national integrity is to tame the craving for “easy fortune” in China and seek new opportunities. The New Southbound Policy (2014), a continuation of the previous Go South Policy (1999), is an exemplary roadmap to follow.
It is time for the international investment club to cut losses in China and run for cover before China’s Lehman Brothers lash out its strikes.
Daniel Jia is the founder of consulting firm DJ Integral Services. He writes analytical reports on public-related matters, focusing on China-related cultural and political issues. There is no conflict of interest to be disclosed.
This article was published as part of a special issue on ‘Farewell 2022 and Welcome 2023’.
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