Evergrande: The Chinese Lehman Brothers?
Updated: Nov 2, 2021
Heavily indebted group Evergrande has been the topic of conversations worldwide. Will China drag the global economy down with them and repeat history?
Hui Ka Yan founded Evergrande, previously known as the Hengda Group, in 1996 in Guangzhou, southern China. Its real estate arm, Evergrande Real Estate, currently owns over 1,300 projects in more than 280 cities in China. Evergrande Group now offers a much wider range of services than just real estate development. Some examples include wealth management, electric automobile manufacturing, etc. It also owns one of China’s largest football teams — Guangzhou FC.
Like the tech giants Alibaba Group, Tencent, which were targets of sudden regulatory crackdowns that wiped out billions of dollars over the summer, Evergrande, in a similar fashion, found itself in the way of the CCP’s (Chinese Communist Party) priorities. Evergrande expanded aggressively to become one of China’s largest companies by borrowing over $300bn. Now, it has become the world’s most indebted property developer.
How did this happen? In the early 1990s, as the country adapted to capitalistic principles, land became collateral for various individuals, businesses, and financial institutions — enabling them to directly participate in real estate markets. This escalated quickly and made the property market a robust driver of economic growth at the time. Evergrande capitalized on this by purchasing large amounts of land, which meant lots of borrowing to finance these purchases. In 2020, Beijing introduced the “three red lines'' policy on property developer balance sheets, to contain the amount indebted by real estate developers. To be precise, liability/asset ratios must be below 70%, net debt/equity ratios below 100%, and cash/short-term debt ratios of at least 1. If developers failed to comply with this, they were restricted from acquiring additional debt. This sudden policy change compelled Evergrande to significantly reduce its prices and offer drastic discounts to ensure steady cash flow to keep itself afloat. Now, it's struggling to service its interest payments on its debts. All the speculation around Evergrande has led to a downward spiral in its share prices, by approximately 80% this year. Its bonds have also been severely downgraded by global credit rating agencies such as Moody’s, Standard & Poor (S&P), and Fitch. More specifically, it received a CC rating from S&P and Fitch, a downgrade from CCC and CCC+ respectively. For Moody’s, it stands at C, a downgrade from CC.
Saddled with almost Rmb 2 trillion worth of total liabilities, it raises major concerns that any failure to repay its debts could pose a broader risk to the country’s financial system and international bond markets, where it has borrowed heavily. The firm’s mounting credit woes have coincided with the government’s regulatory onslaught against the country’s tech giants, the gaming industry, the education industry, and other sectors. Besides, many have bought properties from Evergrande long before the actual building work began. Thus, those who have paid deposits suffer the risk of losing that big sum of cash if Evergrande defaults. According to sources, apparently, over 1.6 million Chinese citizens have paid their deposits to Evergrande, awaiting their finished homes. Looking at the big picture, China’s population is growing at an exceptionally slow rate. In 2020, only 12 million babies were born, a drastic fall from 14.65 million a year earlier in a country of 1.4 billion people. This trend may very well persist as the number of women of peak childbearing age; between 22 to 35, is predicted to fall by more than one-third, further dampening China’s total demand for property.
From a macroeconomic perspective, Evergrande defaulting would incur a substantial credit crunch — implying that companies in China will experience much more pricey borrowing rates, which would discourage investments and lead to a fall in aggregate demand. The property and real estate market in China accounts for nearly 30% of the country’s GDP, so overbuilt that it threatens to jeopardize its long-established role as a main driver of economic growth, and instead, emerge as a macroeconomic headwind. Being the largest issuer of high-yield dollar-denominated bonds, its massive footprint on the housing market generates risks of disorderly collapse which triggers a broader decline in property prices. As a result, global financial markets are bracing for potential aftershocks.
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