Many are wondering if the world is facing a rerun of the 2007–2009 global financial crisis, as China’s Evergrande teeters on the brink of collapse. The answer is probably not, but the implications for China’s economy are profound.
What is happening?
The fall of Evergrande, a massive real estate developer in China, has all the hallmarks of hubris and over-leverage. With more than $300bn in debt, and following the Chinese government’s reining in speculative property development, the group is now teetering towards bankruptcy.
Evergrande owes $20bn in offshore US dollar bonds and is nearing being declared in default, following the failure to pay coupons on time. The company now faces a very expensive restructuring.
The Evergrande debacle might be the tip of the iceberg, with plenty of other developers potentially heading the same way. The aptly named, but much smaller developer Fantasia Holdings skipped repaying $205.7m on its bonds on October 4. Worryingly, everything within this company seemed fine earlier this year and has deteriorated surprisingly quickly.
The situation is likely to get considerably worse before it gets better. Citigroup is warning that 15 Chinese real estate developers are scheduled to repay $5.2bn on their mostly US dollar bonds early next year. Goldman Sachs is warning of considerable funding stress for the sector.
Some commentators are wondering if this might be the trigger for a new global financial crisis. The answer is probably not.
According to Bond Radar, around 120 Chinese real estate companies have $215bn in mostly sub-investment bonds outstanding in US debt markets. The main exposure is likely to be among asset managers — providing they have not used excessive leverage to juice their returns — and it is unlikely that the widespread failure of China’s real estate developers will become a global systemic event. But as learned from the 2007–2009 crisis, interconnectedness and pockets of concentrated exposures can have unexpectedly devastating consequences.
Why is it happening?
A third of China’s economic growth is tied to construction, but the country has significant real estate overcapacity. The authorities realised that construction had become a source of poor-quality gross domestic product growth and is effectively destroying capital.
They took measures such as ordering developers to reduce their leverage and banned high-risk mortgages. Predictably, this knocked the stuffing out of the real estate market and developers face a toxic cocktail of falling real estate prices and being unable to obtain credit.
Unfortunately for China, this coincides with its two other main growth engines coming under pressure, which are exporting and domestic consumption. Countries across the world are moving manufacturing out of China as they no longer trust the country’s regime — this will hurt future export growth.
As for domestic consumption, the government is trying to redistribute wealth to the masses in the hope they will consume more. However, China has one of the most rapidly ageing populations in the world. Pensioners tend to consume less than workers and are dependent on the state for income. This does not bode well for the domestic economy. But it is a very slow-moving trend. China will have to focus on boosting productivity, which is not easy — just ask any Western policy-maker.
But it looks like the halcyon days of eternal rapid economic growth are over; this may hit other indebted industries, as well as countries reliant on China for their exports.
What do the bankers say?
Investment bankers are an optimistic bunch. Despite the signs, many still see years of growth ahead for the Chinese economy and believe that the authorities will contain the collapse of the real estate developers. Bank analysts are clearly more circumspect.
Although the government seems to have little appetite for bailing out Evergrande, it is ordering local governments and state-owned enterprises to take on still viable bits of the business. It also appears to be prioritising Evergrande repaying domestic investors over foreign ones.
Meanwhile, the People’s Bank of China is pumping extra liquidity into domestic money markets to ensure they do not freeze up, and possibly to support banks with big real estate exposures.
Will it provide the incentives?
The Chinese government has done the easy bit of pricking the real estate bubble. Now comes the hard part — containing the fallout.
However, asset bubbles tend to burst quickly and violently, and could force the Chinese government to get more directly involved. The world will watch nervously as they struggle to contain the massive deflating real estate bubble.
