Evergrande debt crisis explained: implications for global markets
By Rob Griffin
09:00, 23 September 2021
By Rob Griffin
09:00, 23 September 2021
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Many investors hadn’t even heard of Evergrande a few months ago, but the Chinese property developer has suddenly become a big topic of conversation.
The heavily indebted company’s future has been hanging in the balance after it admitted that it may default on loan repayments and needed to restructure its debt.
The admission sent global stock markets into a spin, with investors desperately trying to gauge the potential economic fallout if it fails to meet its liabilities.
So how has this situation arisen? Here we look at the problems encountered, the reaction around the world, and what may happen over the coming months.
What is Evergrande?
China Evergrande Group (Evergrande) is one of China's biggest property developers. It was founded in Guangzhou, in the south of the country, by businessman Hui Ka Yan back in 1996.
It has grown rapidly over the last 25 years. As of June 2021, its land bank totalled 214 million square meters in gross floor area, according to Moody’s, the ratings agency.
The business, which directly employs 200,000 people, was heavily involved in China’s housing boom, buying land and building developments in more than 280 cities.
Evergrande debt problem
The company funded its rapid expansion through borrowing and currently owes around $305bn to a variety of banks and financial businesses.
However, government regulation in China’s property sector has been increasing in a bid to control surging home prices and excessive borrowing, according to the World Economic Forum (WEH).
“In 2020, the government imposed the ‘three red lines’ on certain developers to help curb debt levels, forcing them to deleverage,” WEF stated in a report.
Those three red lines required:
1. 70% ceiling on liabilities to assets (excluding advance proceeds from projects sold on contract).
2. 100% cap on net debt to equity
3. Cash to short-term borrowing ratio of at least one.
Uncertainty causes havoc
All the uncertainty has been horrific for the company’s share price. Back in July 2020, the stock reached a peak of 28 HKD. Today it’s just 2.27 HKD. That’s a fall of just over 90%.
In August 2021, Reuters reported that the company had vowed to do everything it could to resolve its debt issues. According to the report, the comments came as the People’s Bank of China and the China Banking and Insurance Regulatory Commission summoned its top executives for talks.
In early September, the company warned shareholders it was at risk of defaulting on its borrowings when it posted a net profit for the first half of 2021. Shortly afterwards, on 7 September, Fitch Ratings, the US credit rating agency, downgraded Evergrande to CC from CCC+, stating that it viewed a default of some kind as probable.
“Mounting investor concern about Evergrande’s creditworthiness has already exacerbated credit polarisation among developers, which has left those with weaker credit metrics struggling to tap debt markets at sustainable interest rates, increasing refinancing risk,” it said.
Global markets became spooked
Unsurprisingly, global markets have become spooked by the ongoing Evergrande debt crisis and anxious about contagion effects. This caused a significant market sell-off towards the back end of October as industry observers debated the possible outcome of the saga.
A string of major indices, including the FTSE 100 and Stoxx 60 fell over concerns that a default could have substantial ramifications for Chinese growth.
These issues would also affect stocks and sectors around the world, which is why the automotive and resource areas wobbled on China demand concerns.
What would happen if it defaulted?
According to Fitch Ratings, numerous sectors could be exposed to heightened credit risk if Evergrande was to default.
“We believe a default would reinforce credit polarisation among homebuilders and could result in headwinds for some smaller banks, although we believe the overall impact on the banking sector would be manageable,” the agency said.
The bigger fear for global markets, however, is the potential knock-on effect on the wider Chinese economy and the potential for a slowdown. It’s this reason why investors have become so unnerved, according to Danni Hewson, a financial analyst at AJ Bell.
“Global markets have been shaken and stirred by the saga because some kind of fallout is inescapable,” she told Capital.com. “The property boom will take a knock and less building will require less raw materials, which is why prices are falling and miners are out of favour with investors.”
Hewson suggested it’s not just the obvious effects that are troubling. “Any fall in Chinese consumer confidence will hurt businesses that have a big Asian clientele,” she said. “Luxury goods and electric vehicles have all seen share prices plunge.”
Effect on the Chinese real estate sector
According to Tommy Wu, lead economist at Oxford Economics, the Evergrande saga has “shone a spotlight” on the entire Chinese real estate sector.
“Financial contagion risks are heightened, not least because the authorities have, thus far, not signalled whether and how they will intervene,” he said in a note to clients.
A key issue is the stance that the government has been taking.
“Amid a campaign to reduce financial excesses and moral hazard, the government would not want to be seen as bailing out the firm or its corporate creditors,” he added.
Whatever happens, Wu expects financial conditions for the broader property sector to remain tight.
“Banks are likely to be reluctant to lend to weaker property companies and all property developers are likely to see higher financing costs in the near term,” he said.
“We may also see defaults of smaller property developers ... amid the authorities’ ongoing campaign to clean up the sector.”
Latest Evergrande news
According to Edward Park, chief investment officer at UK-based investment management group Brooks Macdonald, Evergrande is “on the ropes” and there’s a lack of clarity about what will happen next.
“It is very unclear as to the next steps on this due to the complexity of the Evergrande structure, but bond markets appear to be pricing in a default and low rate of recovery,” Park wrote in a weekly update.
Park pointed out that if Evergrande fails to make scheduled coupon payments, everything could come to a head this week.
“Additionally, there have been reports that property developers will be subject to a Chinese regulatory crackdown over the coming weeks,” he added.
Pressure on Beijing to intervene in the saga has been growing, according to Kunjal Gala, global emerging markets portfolio manager at the international business of Federated Hermes.
“Rather than allow a chaotic collapse into bankruptcy, many analysts predict regulators will engineer a restructuring of Evergrande’s $300bn pile of liabilities that keeps systemic risk to a minimum, but nothing is certain,” he said.
Danni Hewson at AJ Bell believes something needs to happen.
“It’s hard to imagine the Chinese government allowing its economy to be more than slightly bruised by the Evergrande saga but any rescue mission will require a deft touch,” she said.
President’s Xi’s crackdown on private sector excess can’t be ignored, she pointed out, but the “ramifications of complete collapse” seem too great for officials to simply stand by.
It’s impossible to know what kind of deals may be being brokered but without them you’d expect collapse to contaminate a myriad businesses and hammer financial institutions,” she said.
Growth is too important, particularly in light of Covid-19, and confidence crucial, which is why she believes some kind of restructuring is inevitable.
“For investors, it’s the silence that has been the most uncomfortable, a creeping understanding that a bail out isn’t always on the cards and some risks are simply too risky,” she added. “That said if Evergrande’s collapse is anywhere close to being China's Lehman Brothers moment, the silence will be broken and the global markets seem to be pricing that in today.”
Edited by Jekaterina Drozdovica
How much debt does Evergrande have?
It is estimated that Evergrande currently owes around $305bn.
Why is Evergrande in debt problems in China?
It borrowed heavily to finance its operations over the years. Authorities have since moved to control excessive borrowing, however.
What happened to Evergrande?
It has warned investors there’s a risk it will default on its loan repayments. The company’s share price has also fallen around 80% this year.