How an Evergrande Collapse Would Cascade Through China

The country’s supply chain is a strength but also a risk. One big default could lead to a domino effect of small and medium-size business failures.

On Oct. 15, the People’s Bank of China assured investors that China would be able to ring-fence the risks that China Evergrande Group’s collapse posed to the financial system. Representatives from the central bank noted that only one-third of the firm’s liabilities were owed to financial institutions, and that the exposure of individual banks was relatively small.

This is hardly reassuring.

The key to managing the crisis is not just to contain the risk of the financial loans, but also the other two-thirds of the liabilities owed by the distressed real estate developer to a vast network of companies and enterprises in its supply chain — including providers of construction services and material as well as contractors and subcontractors supplying needs ranging from labor to decoration. Even though the PBOC has powerful tools to mitigate an Evergrande shock to the financial system, the fallout could still cause indirect yet long-lasting damage to a large segment of the economy. If not properly managed, this could affect the entire value chain of the property market in China and beyond.

China boasts the world’s most complete supply chain because of its vast manufacturing range. This strength comes with a lurking risk: the sudden collapse of a large non-financial company could cause cascading effects for the real economy at a scale unseen in any other part of the world.

A financially distressed Evergrande could cause illiquidity for its direct and indirect suppliers. Most of them are small and medium-size enterprises that rely heavily on large customers, not only for business but also for access to finance, often in the form of credit extended to Evergrande by the sellers in order to move their product — that is, supply-chain finance.

Amid this crisis, many of these suppliers have had no choice but to accept longer payment terms. When these payments finally come due, the companies are then often asked to accept commercial bills instead of cash. This is effectively a further extension of payment terms, unless the suppliers sell the bills to brokers at a discount. And the trouble can just continue from there. Recently, a broker sued a supplier of Evergrande in a Chinese court for an outstanding commercial bill. The fallout from a collapse by the developer will cause a vast group of suppliers to not only lose business, but also experience immediate financial distress, possibly creating a chain of bankruptcies upstream.

These financial risks are further complicated by the unique nature of supply chains. A major feature is non-substitutability. Unlike the financial sector, where firms can easily switch to other products, there are no easy substitutes in a complex supply chain, particularly in the short term. The collapse of one major developer can cause severe disruption to the rest of the chain.

During the 2008 financial crisis, the interdependence of the supply chain is what led Ford Motor Co. to lobby the U.S. government to bail out General Motors Co. and Chrysler. As Alan R. Mulally, then chief executive officer of Ford, argued, “should one of the other domestic companies declare bankruptcy, the effect on Ford’s production operations would be felt within days—if not hours.”

Another feature of supply chains is the so-called bullwhip effect. Research shows that shocks downstream are amplified as they move upstream. The most recent example is the severe impact that the global chip shortage has had on the automobile sector. That is expected to cost the car industry $210 billion this year. The Covid-related shutdowns of many auto-manufacturing facilities led chip component suppliers to divert their production to consumer electronics. That contributed to the overall shock.

By the same token, the looming bankruptcy of Evergrande and the ensuing financial distress of its suppliers could cause extremely wide and damaging ripple effects.

This is new territory for the PBOC. While the central bank has a good track record of rescuing financial institutions such as Baoshang Bank and the Anbang Group, the restructuring of a large non-financial institution with liabilities on the same scale of Evergrande is unprecedented. The dismemberment of HNA Group, a debt-laden aviation conglomerate, has often been cited as an example for resolving Evergrande. But HNA was in a different sector, one that posed much smaller supply-chain risks.

One solution to minimize future systematic risks to the supply chain is to extend stress testing, already a regular practice for banks, to large non-financial businesses. This effort should be jointly led by financial and industrial regulators. A centralized early-warning system could also help flag potential troublemakers before it is too late.

But that’s the future. For now, simply ring-fencing Evergrande’s financial risks will not be enough to mitigate the dangers its collapse poses for the Chinese economy. China needs a more drastic plan.

Author: Angela Zhang, S. Alex Yang, Bloomberg

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