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Has Evergrande’s Long-Delayed Debt Reckoning Finally Arrived?

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Debt-saddled Chinese property developer

Evergrande

EGRNF -6.67%

has long been one of the so-called “gray rhinos” in China’s debt markets—an obvious, longstanding danger that no one quite knows how to address, but it could be hugely disruptive if the worst-case scenario came to fruition.

The company has managed to defy warnings of disaster for years, but its latest round of troubles may be harder to finesse. Beijing is unlikely to allow a disorderly unwinding of all the company’s massive debts—but that doesn’t mean all investors will be safe if things keep going south. Chinese regulators have substantial ability to corral debtors and creditors onshore and force them to come to an agreement. How an offshore default would unfold, however, is anyone’s guess.

A court order freezing about $20 million of China Evergrande’s assets—requested by one of its lenders—triggered the latest panic. Its Hong Kong-listed shares have fallen 25% in the last two days while its bond prices have sank deeper. Evergrande’s dollar-denominated bonds maturing in 2023 now yield more than 35%.

Evergrande said the loan in question isn’t due until March 2022 and that it will sue the bank for abusing legal procedures. But the fact that a $20 million asset freeze is enough to wipe $4.2 billion off Evergrande’s market value says a lot about its financial predicament. It hints at the anxiety of its lenders, which could kick off a downward spiral if others seek similar remedies.

The developer had about $104 billion of interest-bearing debt as of March, down from last year following the government’s call to reduce debt. But its other forms of hidden debt have gone up. Trade payables have been rising and amounted to $95 billion at the end of last year. The money it owes to home buyers from presold properties also continues to rise.

This week’s collapse comes after the company’s bizarre announcement Friday that it would consider paying a special dividend. That doesn’t make any sense: The money would be better used to repay debt. Regulators will likely frown on the idea anyway. One possibility is that Evergrande could distribute stakes in some of its listed subsidiaries, especially its electric vehicle unit. Removing the indebted EV company—which has yet to sell a single car—from Evergrande’s ownership could improve the larger company’s financials on paper, but it would do little to improve cash flow or soothe creditors. Shares of the EV unit have lost nearly a third of their value this week.

Ultimately, Evergrande’s fate rests with Beijing. The government’s drive to curb property sector debt has weakened funding for developers, sparking Evergrande’s current crisis. Given the importance of housing to China’s overall economy, tightening and easing policies usually come in cycles. But reining in the relentless debt-fueled expansion of companies like Evergrande, which pose an increasing systemic risk, seems likely to remain a top policy priority.

The government will try to contain any ripple effects to the financial system or home buyers but not all investors will be spared pain.

Write to Jacky Wong at jacky.wong@wsj.com

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