The Grand Default of Evergrande

Evergrande has been in news recently, and it's pretty obvious that it's for bad reasons. Some people are dubbing this as the Lehman Brothers moment in China. So let's analyse what is this situation and how bad is the situation and are we staring at another global crisis?

Evergrande: A “Fortune” 500 company

Yes, Evergrande, a Fortune 500 company, the second-largest real estate company in terms of total sales and employs over 200,000 employees. It is a firm with core business dealing in with buying large amounts of land, developing them into houses, restaurants and so on and selling them to interested buyers. The real estate business is a cash intensive business and hence it is obvious that the company uses debt from banks and investors to fund its business. There is no problem with the business if you are able to pay your interest and the debt obligations. However, the problem actually starts when you start defaulting on these obligations, and this is what happened with Evergrande. And when we talk about Evergrande, the company has liabilities on the tune of $300 billion and has to pay around $37 billion in interest and maturing debt over the next one year.

The Beginning of the end:

Though the impact is felt today, the actual trigger was laid way back in August 2020. It was the time when the Chinese government came up with the rules for property developers. This is called the three red lines rule, and these three red lines are:

1. Liability-to-asset ratio (excluding advance receipts) of less than 70%

2. Net gearing ratio of less than 100%

3. Cash-to-short-term debt ratio of more than 1x

If the developers fail to meet one, two, or all of the ‘three red lines’, regulators would then place limits on the extent to which they can grow debt.

For 0 line breach, 15% growth in debt is allowed and 10%, 5% and 0 percent for 1, 2, 3 line breach, respectively.

Though the restriction was mean to control house prices, manage the land market, ration credit to the real estate sector and protect real estate developer who are systematically important, there is something which the Chinese government haven’t thought of i.e. the fall of one of its real estate giant.

The industry, which is highly dependent on debt for its survival, was made to undergo a strict debt expansion policy and the result is in front of us. This was a big hit to Evergrande’s business as it engaged in heavy borrowing to run its business. The company was thus forced to sell its land and other properties at steep discounts to meet its debt obligations. This fire sale of assets, it is said, eventually led to Evergrande’s insolvency.

Why is it dubbed as the Lehman Brothers’ moment? What are the implications?

Chinese people are hooked on real estate investment as compared to the US counterparts; the Chinese people have two-third of their investment in real estate as compared to quarter of the American people. This has led to a huge speculation in the Chinese real estate market, thus creating a bubble. According to a report by Goldman Sachs, the estimated total value of Chinese homes and developers’ inventories has reached $52 trillion, of which 20% of the apartments are estimated to be unoccupied. This shows how deep the problem is in the Chinese real estate market.

But will the implications will be similar to the Lehman Brothers, it's unlikely. There are various reasons for it. First, the Chinese market is subjected to extensive control as compared to the US, which is a liberal market. Secondly, the loans to the Chinese developers are not are not marketable instruments, i.e. these debts are not owned by investors around the world, hence the impact in this case will be limited to China. However, there is a probability of spillover effect considering the size and the influence of Chinese economy on global economy and international trade. This spillover can in terms of the reduction in investments by the Chinese institution in the foreign markets.

So this is all about Evergrande Crisis and if you liked the blog, then don't forget to share it on Whatsapp, Twitter and LinkedIn. And if you have any opinions or views on the same topic, then mention it in the comment section for the readers to understand it in a better way.