Evergrande... There's something very familiar about this?

The scenes of disgruntled investors, crowding the lobby of Evergrande’s headquarters in the Chinese city of Shenzhen, are reminiscent of British savers queuing outside of Northern Rock branches during the Global Financial Crisis. In both cases the root cause has been liquidity issues linked to property.

Northern Rock had been a huge success story. Originally a building society, in 1997 it demutualised and was listed on the stock exchange. By 2000 it was a FTSE 100 company.

While banks had traditionally used the deposits of customers to fund mortgage lending, Northern Rock had borrowed substantially on the global markets, aiming for rapid growth. When the sub-prime crisis hit the US in the summer of 2007, institutional lenders became wary of lending to banks providing mortgages. The bank could no longer meet its repayment obligations and the rest, as they say, is history!

Evergrande, like Northern Rock, has grown rapidly using huge amounts of debt, totalling $304bn[1]. Founded in 1996, the firm is now China’s second biggest property developer by sales[2] and owns more than 1,300 real estate projects in more than 280 cities across China[3]. The firm’s interests are no longer restricted to property, having expanded into other areas, including electric cars, food and even theme parks. Despite the recent problems, the firm was still ranked as the 122nd largest company in the world, by revenue, when the annual update to the Fortune Global 500 list was released in August 2021.

So, what went wrong?

The firm became a victim of the success of the overall property sector in China, which has grown to account for an estimated 29%[4] of GDP, directly and indirectly. To put this in perspective, China is more dependent on the property sector than Ireland and Spain were prior to the 2007 Global Financial Crisis.

Real Estate Related Activities’ Share of GDP by Country

This figure presents the share of real estate related activities in total GDP in China, U.S., U.K., Germany, France, Spain, Netherlands, Finland, Ireland, Japan, and Korea.

Source: Ragoff and Yang (2021)

Concerned that property, predominately financed by debt, made up such a large part of the economy, the Chinese government introduced policies in August 2020 that effectively forced property firms to reduce their borrowing. Rumours that the firm was going to have trouble repaying its debts first surfaced as early as September 2020. In response, it started to offer properties at major discounts to keep the cash flowing in and the business afloat. Such a tactic was never going to be a long-term solution.

In the last weeks of September 2021, the firm missed two payments to offshore investors totalling $131m, a further $162m fall is due in October. The firm has a 30‑day grace period before the non-payment constitutes a default and bondholders can take further action - for example, taking possession of assets, which could ultimately result in the collapse of the company.

While some might draw comparisons to the failure of Lehman Brothers and worry that the fall of Evergrande could have a similar impact on the world economy, the international debt obligations of the firm are relatively low, at $20bn[5]. The real impact is likely to be felt in the Chinese financial system. Reportedly, the firm owes money to 171 domestic banks and 121 other financial institutions.[6] If the firm does collapse, these lenders will undoubtably suffer losses.

As a result of this, a credit crunch, whereby businesses find it difficult to borrow money at affordable interest rates, seems likely. If businesses cannot borrow, they cannot grow, and the ultimate outcome would be a slowdown in the Chinese economy. An additional concern for China is that, although Evergrande has dominated the headlines, there are other large property firms finding themselves in similar situations.

At the time of writing, the Evergrande saga is ongoing. Making predictions as to the final outcome and its impact on the Chinese economy is difficult, if not impossible. The Chinese government may decide the potential fallout from allowing the firm, and others like it, to collapse is too unpalatable and offer a bail-out. This could encourage other large firms to throw caution to the wind and act inappropriately, knowing the government will provide a safety net. Whatever happens, Evergrande’s current situation stands to remind us that, although debt can have its advantages for business, too much debt can be dangerous.


References

BBC. (2021, September 29). China: What is Evergrande and is it too big to fail? Retrieved from BBC News: https://www.bbc.co.uk/news/business-58579833

Evergrande. (2021, October). About Us. Retrieved from Evergrande: https://mobilesite.evergrande.com/en/about.aspx?tags=2

Financial Times. (2021, October 01). Evergrande fallout could be worse than Lehman for China, warns Jim Chanos. Retrieved from Financial Times: https://www.ft.com/content/0bf52d39-fd42-408f-aa85-52a4135de312

Rogoff, K. S., & Yang, Y. (2021). Has China’s Housing Production Peaked? China and the World Economy 21(1), 1-31. Retrieved from https://scholar.harvard.edu/rogoff/publications/peak-china-housing

The Guardian. (2021, September 21). Evergrande: will it collapse and what would happen if it did? Retrieved from The Guardian: https://www.theguardian.com/world/2021/sep/21/evergrande-will-it-collapse-and-what-would-happen-if-it-did

The Wall Street Journal. (2021, October 3). China’s Evergrande Debt Crisis: Sizing Up a Big Mess. Retrieved from The Wall Street Journal: https://www.wsj.com/articles/chinas-evergrande-debt-crisis-sizing-up-a-big-mess-11633253402

[1] The Wall Street Journal (2021)

[2] The Guardian (2021)

[3] Evergrande (2021)

[4] National Bureau of Economic Research (2021)

[5] Financial Times (2021)

[6] BBC (2021)