What is China’s Evergrande Crisis And Should We Be Worried?
Evergrande Group is China’s second largest property developer and home builder company in terms of total sales. The Group has been in the news recently over its inability to pay interest on its huge debt obligations. Lately, the company has showcased its inability to make interest payments and is expected to miss more deadlines. The Wall Street Journal reported that the company’s most immediate deadline was on Sept 23rd, where the company was expected to make an US$83.5 million interest payment due to some of its US dollar-denominated bonds. According to The Wall Street Journal, as of that day, bondholders hadn’t received the money.
Why is Evergrande on the path to default?
The company uses large amounts of debt from banks and investors as well as short-term loans from suppliers and property buyers to fund its business. Looking at the company’s balance sheet, we see that the company’s total liabilities as at June 2021 is approximately US$303 billion and has to pay approximately US$37 billion in interest and maturing debt over the next 12 months. The company’s cash ratio of 0.53x indicates that the company’s current cash balance can only cover a little over half of the company’s current liabilities, which are due over the next 12 months period. As a result of the company’s dim outlook, Evergrande’s bonds have been downgraded by rating agencies such as Fitch and S&P, where Fitch wrote in a recent note, “We view a default of some kind as probable”.
What are the possible triggers for this crisis? Some believe it is a result of the Chinese government new rules for property developers. These rules limit how much property developers can borrow in relation to their financial position. Evergrande was thereby prevented from taking on more debt to run its business. This would’ve led the company to sell its land and other properties at huge discounts in order to meet its debt obligations as their business engages in heavy borrowing to run its operations. This rapid sale of assets is believed to be what eventually led to Evergrande’s insolvency. The implementation of the new rules by the Chinese government can also be viewed as a means to deflate the country’s property bubble. Historically, The Chinese government has supported the property space by encouraging business to take on huge amounts of debt through the heavily backed financial sector. This has led to a massive boost in development of new properties, so much so that almost a third of Chinese GDP is made up of the property sector. However last year the Chines authorities had communicated that they want the country’s resources to be allocated towards other sectors such as technology. Aside from the implementation of the Chinese government’s new rules, there are those who believe the current crisis was inevitable and they argue that the company’s business model has been unsustainable for a long time.
Is the Evergrande crisis spilling beyond China?
While it’s difficult to guess how China’s financial sector will be affected by the Evergrande crisis, Markets are concerned about the effect the crisis will have on other countries. Firstly, investors with direct exposure to Evergrande or the companies linked to Evergrande may experience losses. Some of the biggest emerging market investors hold Evergrande bonds. These include Ashmore Group PLC(US$ 433.1M), BlackRock Inc(US$385.0M), UBS Group AG(US$275.7M) and HSBC Holdings PLC (US$206.9M). Secondly, as the Chinese government tries to rebalance its economy away from the property sector will have an effect on the global supply chain. Metal stocks in India have experienced a sharp decline which is believed to be attributed to fears of a slump in Chinese demand. However, there have been few signs of stress in money and credit markets as well as other areas that indicate that the crisis is spreading beyond China. It is expected that China has more than enough resources to help cushion the blow from a possible bankruptcy or restructuring. Over the last days, the People’s Bank of China has injected some cash into the financial system to help boost liquidity and avoid panic. However, one must ask what does this mean for our current delicate global recovery, which still depends on China to some degree? With the onset of the crisis, one would expect selling of US treasuries to fund fallout, however, with the largest US and European bondholders having an exposure of less than U$500M, this is too small to be called a global financial crisis for the world(and given the support of the Chinese government it is unlikely to be a Lehman type implosion for China). While unlikely, one could eye the possible impacts to commodities tied to the property space, some of which would have already been softened. Going forward, we will keep a close eye on the Evergrande crisis and update our readers on any future developments.
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Written by Jonathan Cook, Investment Strategy Analyst
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