Monday Market Musings >>> Evergrande: China's Debt Bomb Demystified
Picture source: Economic Times Website
Evergrande is a real estate developer company which was started back in 1996 in China. Since then, they have been able to grow and become the second largest property developer in China. The core business is essentially buying empty plots of land and then developing them into large residential structures. Evergrande was even able to diversify their business to other industries such as bottled water, electric vehicles, theme parks and even a streaming service. However, there was a fundamental issue in their business model which ultimately led to their downfall. Debt.
In China the property market was booming as many Chinese citizens saw the house ownership market as a profitable way to invest their savings. What Evergrande did was take loans from banks, investors, and bond bearers to fund the construction of houses and apartment complexes to meet the demand. As long as they were able to sell apartments, they could pay back their loans on time and keep re-applying for more loans and investment. As there is a prominent demand for houses in China, especially with the rise of the middle class, property prices would keep rising. This would fuel developers to borrow more. Evergrande in particular started building up lots of debt, but as long as they were selling houses they were never at risk of default.
When the pandemic hit however, supply chain shortfalls, material price inflation and lockdowns meant that construction couldn’t be completed on time to pay off the investors. This has left the company facing crippling liabilities to investors and banks of more than $300 billion and almost $1.5 million buyers waiting for their finished homes.
Picture source: Reuters website
Evergrande stocks have plummeted by almost 90% in value and payment deadlines are coming in fast. Evergrande collapsing as a company by defaulting on their loan payments will affect thousands of investors and banks worldwide, especially in China.
This has shifted the spotlight to the Chinese government and if they will help to alleviate some of the financial tension Evergrande is facing. Yet officials for the past several years have tried taking steps to cool real estate prices, as they viewed them as a source of risk. Zhu Ning, former advisor to China’s central bank commented “In the central government, the view has shifted over how much China’s economy can depend on the housing market”. China would much rather focus on development of areas where it can relinquish its dependence on the West, such as in technology.
China might let Evergrande fail if they could safely engineer a “soft landing” for the real estate sector to prove a point. However, the risks are extremely high. The property sector contributes to almost 14% of Chinas GDP and Evergrande defaulting will mean the financial burden will be transferred to banks and investors and suppliers who had already invested. This domino effect could potentially completely rupture China’s real estate market and cause thousands to lose their jobs.
China could bail out Evergrande. But that itself could bring a bad image to the Chinese government as this whole situation was caused due to Evergrande’s reckless overextending of debt in pursuit of wealth. This is against China’s core beliefs, and it creates the effect that some companies can actually be “too big to fail.
September 27th 2021 | 3:10 PM