If you faced a charging rhinoceros, what would you do? I like to think I would turn and run, but more than likely I’d stand paralyzed, waiting for the inevitable. Evergrande Group is just such a gray rhino. The Chinese mega-corporation is the second-largest property developer in the country and the 122nd largest business in the world, with more revenue than Disney or Pepsi. But Evergrande is also the most financially precarious business in the notoriously shaky Chinese property sector. Commentators have warned of the sector’s impending collapse for over a decade, but the collapse never came. Let the good times roll. Then, in the past several months, Evergrande defaulted on three bond payments, only to make payments right before the grace period ended, and right before triggering the bondholder’s right to accelerate. The gray rhino is finally charging.

The “gray rhino” metaphor was coined by Michele Wucker to describe a highly probable threat that is ignored despite its potential consequences, and the Chinese property market is an apt example. You don’t have to take my word for it: the Chinese government invoked the gray rhino in 2017 when announcing their intent to curb financial risk in the country. The commentators crowing about distortions in the property market were right, and the government ventured to make the rhino charge on their terms, rather than of its own accord. 

The problem was, and is, that Chinese businesses are overleveraged. Debt has fueled the country’s growth for years, as the Communist Party has regularly set GDP growth targets beyond what many believe is possible with sustainable development. Though China’s debt-to-GDP ratio is similar to that of the United States, a Chinese citizen pays 16% of their income to interest on debt while a US citizen pays 10%. Chinese regulators have swiftly rescued struggling businesses through frequent bailouts. The result of that tender care was that lenders didn’t differentiate between risk levels when making loans. With no downside potential, loans were made to the sector with the highest returns, property development, and the business with the highest returns, Evergrande. 

That lending shot up in 2008, with the government doubling its lending in a single year. Local governments are paid by developers for the land, so new development was a massive boon for the local Party. The free cash and the willing sellers quickly caused supply to exceed demand, particularly in lower-tiered cities — China operates a tier system to rank its cities by size — and rather than allowing the market to adjust, the Party mandated a reduction in housing inventory nationwide. 

So, instead of developing property in new areas, local governments paid residents in dilapidated housing to move out so that their homes could be torn down and replaced with new developments. The Chinese property sector was only privatized in 1997, so the government taking of property was not unusual. The residents were paid both in cash and in new apartments, which of course, the developer was responsible for providing. Rampant speculation followed as people began to buy houses as an investment. With few other suitable investment vehicles in China, this was a natural choice. By 2018, two-thirds of home buyers already owned a home, and it’s estimated that between one-fifth and one-fourth of China’s housing stock is owned by speculators. 

The result is government-subsidized income inequality, with those who received boons from new development able to flip their new assets (since many received multiple apartments as well as cash) doing considerably better than those who did not. This isn’t to say that government intervention in the housing market is the sole cause of income inequality in China, but the intervention in housing markets produced market distortions that lead to massive home prices. Right now, the US city with the highest income to home price ratio is Naples, FL, coming in at 17x income, and famously expensive San Francisco and New York each come in at 8x income. Shenzhen and Beijing are currently at 43x and 42x income, respectively.

President Xi Jinping is trying to steer the state in a new direction and has called for a focus on “high-quality, efficient, and sustainable development,” which he calls “genuine growth” rather than “fictional growth,” or unproductive investment. Genuine growth includes innovation and high-tech sectors, while fictional growth includes growth based on speculation, hence the recent actions against property developers and cryptocurrency miners. 

Here’s the catch: property development is also one of the main drivers of the Chinese economy. Property development accounts for 29% of China’s GDP, much higher than the average of 10% to 20% of developed countries. Plus, with no property tax, at least as of right now, developers buying up land from local governments has been a major driver of revenue. Deleveraging Chinese businesses and reducing income inequality while maintaining growth and generating revenue is a difficult needle to thread for the Party and Xi.

Enter the Three Red Lines and our main rhinoceros, er… character, of Evergrande. The Three Red Lines is a policy rolled out by Chinese regulators in 2020, limiting the amount a developer’s debt may increase every year to 15%. For each red line crossed, that amount drops 5%. The lines are: 1) the liability-to-asset ratio (excluding advance receipts) must be less than 70%, 2) the net-gearing ratio must be less than 100%, and 3) the cash-to-short-term-debt ratio must be more than 1x. What the red lines are isn’t particularly important. What is important is that they have seriously tightened the belt on Chinese property developers: as of January 2021, Standard & Poor’s estimated that only 6.3% of their rated developers could comply with all three lines. Of the largest 30, 15 have crossed at least one line. Evergrande has crossed two, limiting the amount of debt it can take on to only 5% above last year. 

Even before the Three Red Lines, Evergrande got creative in its fundraising, which is why its potential collapse could be so disastrous. First, their business model involved taking on considerable debt to fund future projects. Evergrande would take a loan from a bank to buy property from a local government to develop, then, before a shovel was in hand, sell the apartments to buyers. This was easy because of the rampant speculation. Second, Evergrande would pay contractors working on the project in commercial paper rather than cash, so there wasn’t any money walking out the door. Third, Evergrande issued a Wealth Management Product (WMP), an investment vehicle regulated by local financial asset regulators rather than national banking regulators. Though relatively common in China, WMPs are of dubious quality, and for Evergrande, it was like letting your landlord be your investment banker. Many apartment buyers were pressured into buying Evergrande’s WMPs when buying apartments. Because people were buying their apartment more for its value as an investment vehicle than for its value as a home, few thought twice before investing considerable sums into Evergrande’s WMPs as well. In this way, Evergrande’s business model was more akin to an investment company whose principal asset was real estate rather than a property developer. 

While pre-selling homes, paying contractors in commercial paper, and offering WMPs is not uncommon for Chinese property developers, the reason why Evergrande is at the center of the current crisis is that they still needed more money. For that, they looked to their employees. Evergrande employs a lot of people. First, they turned to executives for funding, but when they ran dry, Evergrande offered investment vehicles to employees further down the org chart. Seventy percent to eighty percent of employees were offered the investment, and many were pressured into investing with the threat of losing bonuses. Called chaoshoubao, the employee investment vehicle promised incredible returns. As you may predict, those returns never appeared. 

Now that Evergrande cannot take on any more debt to fund its operation, employees are rightfully angry and protesting at Evergrande’s offices. As disgruntled employees have taken to both WeChat and the streets, the Party has responded by silencing dissent and deleting WeChat posts. 

Perhaps the only upside of this unfortunate situation is that the risk of Evergrande’s collapse, or the collapse of the entire Chinese property sector, poses only a small risk to the international financial system. Unlike the collapse of Lehman Brothers, where most of the creditors were international financial institutions, most of Evergrande’s debtors are local to China. There is some risk of contagion, as large funds such as UBS and BlackRock have investments in Evergrande, but compared to the amount of Evergrande debt held by Chinese citizens, this amount is low. 

With the threat to Chinese citizens so high, naturally, Chinese regulators are keen on giving Evergrande a smooth landing. Evergrande paid their last three bond payments a day before the grace period was up, but no one is quite sure where they got the funds to do so. Potential suitors for pieces of Evergrande’s business have been dissuaded by the amount of debt held, but some sources have floated that the government will not factor in acquired debt when calculating whether the acquirer has violated the Three Red Lines. Where developers were a major source of revenue for the local Party, the government has increased the amount of land purchased for infrastructure projects. State developers bought 75% of the land sold at auction in the past three months, up from 45%. The state hasn’t totally closed the gap for local governments. One-third of auctions failed for not reaching the reserve price, up from 6.3%. Finally, while I don’t want to in any way condone the suppression of dissent, by suppressing news of protests, the Chinese government is reducing the amount of panic selling in the market. The secondary market for the commercial paper issued to contractors is the main area of concern for panic selling, and up to this point, things seem… normal. 

China seems to have dodged Evergrande’s gray rhino by forcing it to charge before it was ready. What remains to be seen is whether it will double back for another round. 

Author Bio: Evan Conner is a 2L at The George Washington University Law School. He is interested in debt and financial technology issues and how those issues appear in the global economy. Outside of law school, he enjoys making coffee and arguing about music in TikTok comment sections. He received his Bachelor of Music in Sound Recording Technology from the University of Massachusetts Lowell.