One of the gravest risks in the global economy is the changing stage of how old we're all getting.
How few kids we're having.
And as a consequence, how we will really grow.
For all the talk of numbers, statistics to do with growth, manufacturing, services, spending (you get the picture), everything boils down to 'who is going to work? How are they going to work? What will their work look like? And what does it mean if fewer and fewer people are working?'
In this piece, we start by looking at China's largest property firm to introduce the theme of demographics, and how, in the world's second largest economy, labour and population issues could cause calamity not just for China, but for the global economy as a whole...
Back in 2019, we had a bit of an inkling that the largest property firm in China by assets, Evergrande, was in for a bit of a tumble.
And tumble it did.
Naturally, a lot of this was to do with the virus, but there are now longer term factors at play that I seriously reckon we need to focus on.
I quite like this meme to explain the situation.
I won't give up the day job to become a meme maker.
Some financials to scare you with...
Since I'm not a balance sheet and financials nerd, I have enlisted some help on this analysis.
We'll get back to the macro after.
This is from InvestmentTalkk, a properly intelligent fella.
Evergrande, the real estate darling of China.
At first glance, it appears like a straight-A student. However, it would take a prudent investor just five minutes of legwork to reveal that this company is, in fact, a troubled child.
Early in 2020, the Chinese Central Government announced concern over the domestic housing market, restating their mantra that “housing is for living and not for speculation.”
To reduce the dependence, the broader economy had on the housing market, as well as combat rising housing prices, government authorities cried for stricter financial regulation in the sector, as well as the desire to deleverage certain players, Evergrande included.
This is a concentrated sector where the ten largest real estate firms control ~30% of the market.
The appetite for construction in China has been insatiable over the last decade, that is clear.
But so, too, has the appetite for debt.
Evergrande’s long-term debt has ballooned by ~960% from 2012 to June 30th, 2020, when the latest filings indicate the carrying value of how much they owe.
From 2012 to 2019, Evergrande’s revenue, gross profit, and operating incomes failed to match the pace of growth exhibited from both their long-term debt and interest expenses from borrowing.
As per the most recent filing, Evergrande held 439,784 million RMB in long-term debt, or ~$67 billion in USD.
So, this pertains to the amount of debt that Evergrande hold which is expected to mature some time in the future.
More specifically, any debt which is not maturing within one year, which would be considered ‘current’ borrowings.
Current borrowings, as of June 30th, 2020 stood at 395,687 million RMB, or ~$61 billion.
That is nearly $130 billion USD in short-term and long-term debt. Total debt, both short and long term, has grown 1,286.14% from 2012.
Real estate is an industry which typically operates on lower levels of liquidity, and greater volumes of leverage.
So, without context, this may appear normal.
This tends to be the case with other heavy asset markets such as manufacturing and telecoms.
Absorb what we have just discussed, as we will be coming back to the debt discussion shortly.
Evergrande reported ~$73 billion in sales in FY19, up a modest 2.6% on the year. For the 6 months period ended June 30th, 2020, they reported ~$41 billion in revenues.
Gross margins tend to oscillate around the 30% range during normal years but have sunk to closer to 25% after the impact of coronavirus.
Similarly, operating margins tend to be somewhat more volatile and have a wider standard deviation, often reporting between 15% to 30%. As of Q2 FY20, it stood at ~18%.
Let us paint a picture for a moment to best illustrate the point I am about to make.
In FY19, Evergrande reported ~$73 billion in revenues, with ~$20.5 billion in gross profit.
After deducting operating expenses, they are left with ~$14.5 billion in operating income.
From that operating profit, ~$3.2 billion in is shaved from the earnings, mostly contrived of finance costs, which are the fees incurred to service their debt.
These fees amount to ~$3.5 billion for the full year, after some offsetting gains accounted for through their revision of fair value financial assets.
After income taxes, the company reported ~$5.2 billion in earnings for the period.
This seems like an inexpensive cost of debt when we consider they own held close to $130 billion in total borrowings at that point.
I argue that income statements are the least useful financial statement, simply because they can be so deceptive.
As it happens, Evergrande pay a great deal more in fees from borrowing.
During FY19, the company actually racked-up ~$10.5 billion in interest expense but opted to capitalize 75% of it so that it does not hit their income statement.
When incurring expenses, there are certain conditions which may lead to a company expensing the cost or capitalizing the cost.
Typically, costs incurred with respect to debt will be recorded under the operating profit line as interest expense and shave some margin from the earnings.
If a company capitalizes an expense, they are adding the cost of whatever it may be to the balance sheet.
This simply delays the recognition of the expense until a later date, as opposed to recognizing it within the period it is incurred.
One of the conditions whereby a firm would capitalize their interest expense is under the construction of fixed assets.
So, imagine Evergrande raise some debt, and proceed to use that debt to finance some new fixed asset.
The costs of sales tax, labor, transportation, and interest incurred to finance the asset, will all be added to the value of the fixed asset on the balance sheet.
The interest expenses would then be slowly recognized, over a longer period, as depreciation or amortization expenses, which impact the profit and loss on the income statement eventually, but to a lesser extent, and spread over a longer period of time.
The act of capitalizing interest expenses is legitimate and, alone, does not indicate foul play.
For me, red flags start waving once a company engages in aggressive, and prolonged capitalization.
In the below chart, I have plotted interest expense from FY12 to FY19. The far left indicates the total interest expense, the middle represents the amount of capitalized interest, and the right-hand side reflects the interest expense that was placed through the income statement.
Each segment is reported, relative to operating income, which is the most appropriate anchor, given that interest expense is deducted from this line item.
Over the period from 2012 to 2019, Evergrande have become more aggressive with their capitalization.
In FY12, total interest expense represented ~35% of operating income.
The same year, the company opted to capitalize 99% of those interest costs, with the remainder being expensed.
As a result, the amount of interest expense hitting the income statement was shaving less than 1% from the operating income.
Fast forward to FY19, and the total interest expense represented ~54% of operating income.
During 2019, Evergrande capitalized ~75% of those costs, with the remainder hitting the income statement.
The amount of interest expense that was expensed through the income statement that year, shaved ~18.5% from the operating income.
Over this period, Evergrande have demonstrated that they have reduced their ability to finance their interest expense with their operating income, both for interest that is capitalized, and that which is expensed.
Although, as we made clear, capitalized interest expense will not be recognized for some time.
Quite simply, the cost of their debt is growing faster than their operating income.
In theory, capitalizing your interest avoids the requirement to recognize it on the income statement.
Back in 2012, Evergrande capitalized, essentially, all their debt costs, with less than 1% seeping through to profit & loss.
They were sweeping the dirt under the rug.
Eventually the dirt builds to a level whereby you can no longer ignore it’s presence.
This is most prominent when the company faces some external force for which they had no anticipation, like coronavirus.
For the 6 months until June 30th FY20, operating income fell 22% from the previous year, standing at ~$7.3 billion.
Expensed interest for this period, excluding exchange losses and other costs, amounted to ~$1.2 billion, or 16% of operating income.
Capitalized interest for this period, accounted for close to 72% of operating income, at ~$5.3 billion.
Recall that management possess some level of discretion as to when they capitalize, or expense, these costs.
When seeking to understand the legitimacy of financial reporting, and subsequently the quality of earnings, it can help to understand if management are operating in an environment that is conducive to issuing low quality reports.
There can be environments whereby management may feel pressured to issue low quality reports to meet certain objectives, such as earnings estimates, debt covenants, reputation, credit rating, and so on.
The three key conditions which are most often present, with respect to financial manipulation, are opportunity, rationalisation, and motivation.
Each of these factors, if present, form the fraud triangle.
Motivation and opportunity are certainly present with respect to management’s ability to capitalize heavily.
Pressure on the bottom line can be easily alleviated through a reduction in expensed interest, instead opting to capitalize.
Okay, so why don’t Evergrande just use some of their cash to pay down a chunk of their debt, and reduce their interest expense?
- They do not have to. If the debt markets remain open and willing to lend, they will continue to absorb more debt, capitalize the costs, inflating their assets, and repeat.
- They do not have any cash.
Okay, so they do have cash in the bank, around $21 billion as of June 30th FY20.
However, their outstanding debt due within the year dwarfs this figure. Cash represents just 7.3% of their liquid assets, with 65%, or ~$192 billion, being held up in properties under development.
Their liquid assets are not all that liquid. But there is a solution.
Raise more debt!
Below, are the cash inflows and outflows of the business from FY12 to FY19.
Over this period, the company have failed to report an operating cash inflow.
Instead, the outflows widened from 2012 to 2017, before getting slightly less horrific in 2018 and 2019. But still horrific all the same. Free cash flows? Forget it.
Why is this important?
Operational cash flows represent the cash the company generates, through their operations.
We take the operating income and add back various non-cash expenses such as depreciation and changes in working capital and offset with taxes.
Free Cash Flow is cash flow from operations, but we deduct the valuation of any PP&E over the period.
What we have left, is the amount of cash the company has at hand, to spend on internal investment, dividends, share repurchases, paying down debt, add to their cash reserve, and other important aspects to remaining as a going concern.
If a company were to, like in Evergrande’s case, possess negative operational cash flow, then the company can only survive, or fund their operations through additional capital injections from equity or debt issuance.
During 2019, Evergrande paid interest that totalled more than 3.5 times their net cash generated from operating activities. That was before they even paid income tax.
Cash inflows have almost exclusively been the result of debt issuance over the last decade.
Growth comes at a price, and Evergrande’s price is a crippling reliance on debt.
To put this into context, this company could have anywhere between $40 billion to $60 billion in current debt, for example.
Yet the only alternative they must pay this debt, is by selling assets, or raising additional capital.
The United States has a fair share of debt giants, such as legacy telecom provider, AT&T who currently possess $155 billion in long-term debt.
The key difference here, is that AT&T generate sufficient levels of free cash flow to pay the debt, without necessarily relying on additional capital injections to fund their operations.
Over the last three years, AT&T have been slowly reducing their outstanding debt through consecutive negative net debt issuance years in 2018, 2019, and 2020.
Below we can see the current portion of long-term debt, updated each quarter, as well as the level of annual free cash flow for both businesses.
AT&T’s free cash flow has been increasing over the last five years, whilst their current portion of long-term debt remains stable.
To their credit, they are great at structuring the maturities timescale of their debt.
Evergrande, on the other hand, have perpetual negative free cash flow, coupled with an expanding current portion of long-term debt.
This is not an advertisement for AT&T, but rather an illustration that one can be incumbered by debt, but still possess the ability to appear in control, which I feel AT&T are.
Whilst also demonstrating the ludicrous nature of Evergrande’s actions.
Chinese regulators are in a precarious position.
After a frantic and debt-fuelled economic expansion, debt to GDP levels is among the highest across the global economy.
With Evergrande being told to deleverage, and there appearing to be no legitimate way for them to do so, without jeopardizing their status as a going concern, I believe there are vastly more attractive pockets of the market for an individual investor to be concerned with.
Cheers for that, I.T.
So basically, short?
The financial position of Evergrande looks to be one that is under severe duress.
But there is one big issue that a shorter might face here.
And that lies with the CCP.
There is a political will in China to appear strong, and the corporate sector is naturally where this will be noted the most.
China has around 10,000 zombie firms with approximately 2000 of these being funded directly by the central government as of 2019.
'Zombie enterprises are characterized by low operational efficiency and production, and they suffer from long-term losses or insolvency. They consume social funds and resources, and although they should have been eliminated by the market, they continue to exist (Chen, 2015).'
The problem with zombie firms is that they operate, and contribute heavily to, overcapacity in the industries in which they function.
Firms which should have failed, because the market dictates them to, are being propped up - during an economic shock, it ends up being that these 'bad' firms win bigger than those that are operating productively.
The problem there is that this is likely to exacerbate economic problems further down the line.
In China, there's an element of 'cultural shame' and possibly fear as well, the root being the government.
Local officials have a political incentive to avoid social unrest; or shame.
Party Secretaries tend to direct more credit to non-zombies in the early years of service because it may take a few years for non-zombie firms to transform credit resources to profitable projects and the payoff of investment tend to be lagged; thus, early lending support will be more beneficial.
In the later years of service, Party Secretaries will substitute lending to zombie firms for lending to non-zombie firms, as helping zombie firms is one of the limited short-term instruments that can be used to avoid a surge in unemployment and maintain performance at the end of a cycle.
The author goes further to note an important difference in where lending comes from on a more global basis...
There is cross-country evidence of increased lending from government-owned banks in election years relative to private banks.
Similar patterns and tactical redistribution (more loans are made in more competitive areas) are found in India for agricultural credit lent by government-owned banks (Cole, 2009), in Brazil for state-owned banks to shift employment toward politically attractive regions (Carvalho, 2014), and in Germany for savings banks that are controlled by local politicians (Englmaier and Stowasser, 2017).
It goes a little further...
The fact that local Party officials are not subject to elections would seem to insulate them from political pressures. However, I find political manipulation of bank lending across the appointment cycle.
Local officials target zombie firms (or more generally, target different types of firms in different periods) because of career concerns.
In China, the personnel control of the Chinese Communist Party (CPC) and government leaders has a highly centralized structure.
Higher-level officials control the selection and (re-)appointment of lower-level officials.
Economic performance is the most important indicator in personnel evaluation.
Now, let's consider the extent of workers in construction in China in this 'economic performance' measure.
Evergrande itself has 133,000 or so employees and is the largest employer in the sector.
There are 54.3 million construction workers in China.
These numbers are pretty big, and they're a large cross section of the labour force to appease when you consider that there are about 775 million workers in total in China.
It's about 7% of the labour force.
And then we get to headlines such as the one below...
Property is ingrained into the Chinese culture as a source of stability yes via the asset itself, but also via the employment it generates.
Here's a really interesting point from the same author above on the broken mechanism of zombie firm creation, specifically to China...
When faced with an insolvent borrower, a bank usually is not willing to immediately start the liquidation process because it does not want to recognize the loss and lead its own balance sheet to deteriorate.
Instead, it will reduce the interest payment, roll over the loan, or issue new loans for the firm to pay back the old loan, expecting the firm to recover soon or the government to bail it out.
Moreover, by downgrading the loan, the bank will automatically reduce its capital adequacy ratio (CAR), which, if it falls below a minimum regulated level, will induce large adjustment costs.
Therefore, a minimum CAR constrained bank (CAR lower than 8% in China) will try to avoid downgrading the loan in order to maintain its CAR.
The mechanism is broken!
Chinese banks reckon the government will do whatever it takes to save the economy, so don't mind continuing to lend to firms that are in the toilet.
Paul Tudor Jones said it best...
And there is a big, big issue with the Chinese shadow banking sector.
Shadow banks are described by Investopedia as...
the group of financial intermediaries facilitating the creation of credit across the global financial system but whose members are not subject to regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions. Examples of intermediaries not subject to regulation include hedge funds, unlisted derivatives, and other unlisted instruments, while examples of unregulated activities by regulated institutions include credit default swaps.
This paper sheds some light on the issue and says...
Indicators of shadow banking activity have a positive effect on house price growth.
But it comes to the conclusion that Chinese housing is not in a bubble...
That there is not evidence of bubbles does not mean property is not risky. Growth stocks are risky because small changes in expected growth of earnings (in this case rents) can lead to big changes in value.
Bear in mind that this was written in 2016...
And then two years later we had people protesting at falling property prices then I think we might gauge that there is probably a bit of a bubble, especially when the oversupply of housing is factored in (ghost cities).
And if there is a link between the financing from the shadow banking sector and house prices, then there could be a bumpy ride in store, as Harry Hu from S&P Global mentions...
The shadow banking sector has a substantial portion of real estate and [local government financing vehicle] financing, there are stricter macro level financing policy restrictions on both these sectors. The trust sector has more explicit caps on real estate financing.
Not a great combo and please refer back to this when you see the chart below of where we are in the demographics vs non-financial corporate debt stage.
It's pretty compelling.
Which leads us nicely onto the next segment.
China has been 'cracking' down on zombies...
I put cracking in quotation marks because it hasn't reeeeaaaallly been doing that.
Since 2015, there has been a policy known as 'jiangshi qiye', or 'the dismantling of zombie firms'.
Between 2015 and 2018, bankruptcy cases in China increased by about 500%, but many weren't completed because of political connections from the zombies themselves, the power of local banks and the local governments, as described above.
No, I can't read Mandarin, but that's the government's official release.
The CCP said in 2019 at the State Council Meeting...
All relevant parties must not hinder the exit of these zombie enterprises, and noted that government offices should not use subsidies.
The virus has certainly not helped this being achieved...
I hear the thoughts whizzing round your head...
THEY CREATED THE VIRUS TO NOT HAVE TO SHUT THE ZOMBIE FIRMS DOWN.
Just me then.
Has anything changed?
In 2019 at Jinping's New Year speech, he said...
2020 will be a year of milestone significance.
We will finish building a moderately prosperous society in all respects and realize the first centenary goal.
2020 will also be a year of decisive victory for the elimination of poverty.
Yeah, about those improvements in debt and the elimination of economic drag...
Wonderful decrease there; really hitting those targets.
And China's non-financial corporate debt to GDP just hit an all time high.
And they've just started defaulting on $ denominated bonds at the fastest pace ever too...
Naturally, a broad risk here is if we have a stronger dollar, making that debt more costly to repay.
Should we care?
I mean, yes, of course we should.
But the problem is that sounding an alarm like this has been done over and over again for the last 10 years.
Which is why looking at firms that are at greatest risk of stagnancy, whilst being systematically important is vital to assume a stance from a broader perspective - such as Evergrande.
The term 'zombie firm' stemmed from Japan's lost decade, where similar misallocation of credit cause economic stagnancy, which they're still experiencing until today.
So the problem isn't with China blowing up or anything ridiculous like that...
No, it's the same issue that I return to.
That they just trudge along, with no real strong prospect of resurgence.
This is a massive political risk for the CCP, demonstrated by their political desire to prop up failing firms.
It brings to mind this picture.
By misallocating capital like this, there is a 'snake eating its own tail' environment where the can is kicked further down the road, albeit, each time the can is kicked, the foot gets more and more sore.
And speaking about economic drag, there is perhaps a more global, but still China centric problem to contend with.
I don't want to make exact comparisons, since the economies are pretty different...
Take a look at this chart.
Could we make an assessment that China is going through the same period of deflation and stagnancy as Japan did?
We can look at demographics to make the point more visceral.
From well known China-fan, Robert Kuhn...
China is getting broadly old before getting broadly rich.
That’s a dark, demographic cloud on the socio-economic horizon. In 20 years, China’s elderly will double from 10% to over 20% of the population.
By 2050, 330 million Chinese will be over age 65, and China’s “dependency ratio” for retirees could exceed 40%.
This means that there would be only (roughly) two working adults bearing the full burden of supporting one senior citizen.
A typical young working couple will have to support four elderly parents, putting unprecedented pressure on the family bonds that hold society together.
Adding the number of children below 15, the dependency ratio could reach 70 percent — and there is insufficient wealth to create a national safety net.
Again, we come back to the demographic changes.
And it's pretty damning.
Check the working age population sizes at times where non-financial sector debt to GDP peaked...
Now, yes, China is a very different economic being than Japan...
But in 1993, Japan also had similar (in fact, lower at 147.6% of GDP) non-financial corporate debt to GDP levels than China do now (162% of GDP) - just after they entered their lost decade.
And we know what happened to inflation and growth there after that...
See the China vs Japan inflation chart above.
Japan faced stagnant growth after its working population started to decline.
The connection here is with productivity of firms (overcapacity from zombies being propped up), debt and demographics.
And there is no sign of let up in the demographic degradation, like with many other developed economies, which is the driver of economics - but it's almost as if there is no foresight to see it, or at least, there has been nothing done to improve the demographics and as a result, the composition of the labour market.
Where does Evergrande tie into this?
Without a managed deleverage, I see the demographics of China causing severe issues for property firms, Evergrande naturally being the number one.
One caveat to China awakening from a slumber is if the savings rate decreases.
If there are indeed pent up savings across generations and the culture changes, then there is certainly room for more growth from domestic spenders.
But this is a big if.
If families are having to support older parents (it's expected that by 2050, a Chinese couple will have to support four elderly parents) then this could certainly eat into that consumption narrative, and as a result, the demand for housing would likely fall further, especially when we consider that it is already over capacity.
As you may note, we have been extremely determined at looking at demographics, the labour market and the results of the two, which indicate across most developed economies, that there is a big disconnect in the future unless something turns around rapidly.
The high growth story of China is unlikely to continue as these demographics worsen, but it would be dishonest to say that this would happen soon and we are not in the business of scare tactics like many writing about global issues.
Instead, it is something to pay attention to as a long term theme through your life as the world changes, creating, and destroying, opportunity.
Evergrande is a darling of China.
The faucet of where much of China's post-Mao story has been developed from.
Property, like in many other countries in the world (but strangely it is so sacrosanct in a communist state) is of vital importance.
But this importance and leverage could serve to undermine the prospects at some point in the future...
Again, not collapse, but a slow trudge into the similar mediocrity and apathy that many face in even more 'developed' countries.