By Alisha Tan & Queenie Mok
Evergrande is the second largest property developer in China. The company currently has 1,300 ongoing projects in more than 280 Chinese cities. However, this Fortune 500 company is in trouble, with ramifications that could reach all parts of the world.
Evergrande was founded in 1996. Due to the urbanisation of China, demand for housing increased significantly. Evergrande rode the wave of higher prices and grew quickly by pursuing a ‘three highs one low’ model of growth — high debt, high leverage, high turnover and low costs. The group used their land as collateral to borrow and expand. With record low interest rates around the world after the Global Financial Crisis, Evergrande increased its leverage.
The company stretched into other industries that ranged from health, football academies to theme parks. In 2017, the company started to transition away from its high leverage model. However, this did not stop the company from accruing more debt. Today, Evergrande is the world’s most indebted property company, with US$300 billion worth of liabilities.
Why is Evergrande in trouble?
In the past, Evergrande was able to borrow continuously without issue. However, due to concerns over the amount of debt held by property companies and the overheating property market, since late 2015, the Chinese government has enacted a range of policies aimed at decreasing leverage and demand for property. Debt growth decreased from 53 percent in 2017 to 16 percent in 2019.
In August 2020, China announced further restrictions. The People’s Bank of China and the Ministry of Housing introduced the ‘three red lines’ policy to assess a developer’s financial health. The three requirements were:
- Cash to short-term debt ratio of more than 1x
- A maximum net debt-to-equity ratio of 100 percent
- A maximum liability-to-asset ratio of 7 percent
Evergrande immediately failed all three lines, meaning that it could not grow its debt.
The company set about reducing its liabilities, including selling its property stock at a discount to increase sales. However, this was not enough. China’s property market has suffered a slowdown due to the pandemic, meaning that despite its discounts, Evergrande’s sales continued to fall.
Although Evergrande’s borrowings decreased, its liabilities increased in the earlier quarter of this year because of rising suppliers’ obligations. More suppliers and contractors started suing Evergrande for lack of payment. In July, rating agencies S&P, Moody’s and Fitch started downgrading Evergrande bonds. The People’s Bank of China and the China Banking and Insurance Regulatory Commission publicly stated in August that Evergrande must ‘actively diffuse debt risk and maintain real estate and financial markets stability’.
Despite its efforts to raise cash, Evergrande started missing payments. The company has repaid some of its debt obligations to onshore investors. However, so far, it has missed two bond payments to offshore investors.
The potential implications of an Evergrande collapse
Being the second largest property developer in China, Evergrande’s collapse could cause shareholders, investors and other companies, including construction firms and suppliers, to suffer major losses and potentially cause them to go bankrupt. Evergrande has failed to meet its promises with more than 70,000 investors, and it has more than 160,000 direct employees and over 3.8 million jobs related to its projects.
However, the possible impact could reach so much further than simply the companies and investors Evergrande has dealt with directly. Given that the Chinese economy is the second largest in the world and the property sector makes up 25 percent of China’s GDP, there are potential dire consequences for the rest of the world.
Will Beijing bail Evergrande out?
Evergrande is too large for another Chinese company to purchase, and the Chinese government is one of its only potential saviours. Until now, Beijing has remained silent on whether it will come to Evergrande’s aid.
Despite the potential aftershock of a collapse of China’s second largest property developer, Chinese regulators may be unwilling to bail Evergrande out as they want to reduce moral hazard. In line with its aim to deter other large corporations from engaging in risky market behaviour because of the belief that they will be bailed out when things go south, Beijing may seek to make an example out of Evergrande and choose not to come to its rescue. However, many strategists believe that Beijing will not let the company fail to prevent a global financial collapse.
There are fears that a credit crunch will occur, causing a global financial crisis like the one seen in 2008. Evergrande reportedly has loans with 171 Chinese banks and 121 other financial firms. It is possible that investors may simultaneously withdraw their cash from financial institutions, which will cause banks to lose their ability to meet their funding or lending obligations. This would make it more difficult for banks to lend money to other borrowers at affordable rates. If companies can’t easily access funds, it will be difficult for companies to grow, and possibly even continue operating.
Global Financial Crisis
A crash of China’s property market would be detrimental not only to China’s economy but could also cause a financial crisis within the global economy.
China is Australia’s largest trading partner, and a crash of the Chinese economy will inevitably have significant impacts on Australia’s economic growth and Australian commodities, including iron ore, Australia’s most valuable export.
As the Chinese economy is the second largest in the world, it is obvious that Evergrande’s collapse could send shockwaves to the rest of the world. The anxiety over Evergrande has already caused market sentiment to drop, with investors fearful of the future and uncertainty – the S&P 500 fell 5.2 percent between the 2nd of September and the 20th of September.
However, some analysts believe that the financial risks of an Evergrande collapse will be well contained and will not cause another global financial crisis, given that Evergrande is just a property developer and not a major investment bank. Nonetheless, the global financial system may still be facing the largest hurdle it has seen since the global financial crisis; only time will tell.
Sources: New York Times, Bloomberg, NBC News, Australian Financial Review, South China Morning Post, UBS, Reuters, ABC News, Forbes, CNBC
The authors of this publication are not qualified to provide financial or investment advice and as such the content provided should not be construed in this manner. All information is intended purely for educational purposes and is provided for the personal interest of UNIT members. The opinions expressed within the article do not reflect those of UNIT as an organisation, its partners or its sponsors.