- Evergrande is China’s second largest Real Estate company.
- As the company struggles to repay creditors, global markets have responded with selloffs.
- Evergrande debt is now is over $305 billion.
- Questions loom about a government bailout and whether Evergrande is in fact too big to fail.
Evergrande, now the world’s most indebted real estate company, is on the brink of collapse and the news sent global markets tumbling during trading on Monday. The company has warned investors that it could default on its debts and ratings agency Fitch has said that default ‘appears probable’ while Moody’s, has said ‘Evergrande is out of cash and time’.
Evergrande (previously Hengda Group), founded by Xu Jiayin in 1996 and headquartered in Shenzhen, China, rapidly expanded during China’s housing boom, buying land and delivering over 1300 market-rate and luxury apartment developments in more than 280 cities across China.
As residential sales began to slow in recent years, Evergrande debt increased and the company diversified into other sectors such as electric vehicles, football and even bottled water. Evergrande employs 200,000 people directly and indirectly is responsible for an estimated 3.8 million jobs annually.
So what went wrong?
While it is still not clear what will happen to Evergrande in the coming days... what is clear is that the world needs to closely monitor asset prices and debt levels to preserve the health of an already fragile global economy.
—Alice Charles Project Lead, Cities, Infrastructure and Urban Services Platform and Kalin Bracken Lead, Real Estate, World Economic Forum
A regulatory storm brewing
Government regulation in China’s property sector has been increasing as the government has been working to control surging home prices and excessive borrowing.
In 2020, the government imposed the ‘three red lines’ on certain developers to help curb debt levels, forcing them to deleverage. The three red lines policies require:
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
This resulted in Evergrande unsuccessfully trying to sell off some of its business, evidenced by a leaked letter from Evergrande to the government in September 2020 asking for assistance as they faced a cash crisis, which sparked increased investor concern. An estimated two thirds of Evergrande’s obligations are to homeowners who pre-paid for close to 1.4 million residential properties that remain undeveloped.
The government has also worked to control housing prices, which could further impact developers’ returns and the ability to pay their debt service. Housing is a key source of household wealth in China and if the government succeeds in curbing residential property prices, existing mortgage holders could lose equity in their homes. Household debt now stands at 62% of GDP in China, which has largely been acquired through residential mortgages. This is one reason for such a large amount of Evergrande debt.
The increasing regulatory environment in China could also be a deterrent to continued foreign investment as seen recently when Blackstone abandoned plans to acquire SOHO China due to prolonged regulatory reviews of the deal.
Evergrande debt - A domino effect
As early as 2018 the Chinese Central Bank highlighted in its financial instability report that companies like Evergrande could pose a systemic risk to the nation’s financial system. Evergrande has an enormous web of contractors and other businesses in the region that are owed money from the developer.
In recent weeks contagion fears have intensified as 128 banking institutions and 121 non-banking institutions are exposed to Evergrande.
On Monday, the S&P 500 fell 2.24%, its worst day since May and the VIX, an index which measures S&P volatility, hit 26.7%, its highest jump since May. There are also concerns around the impact on commodities if demand wanes due to slowing construction, with metal prices taking a hit during trading on Monday.
Despite Evergrande’s efforts to lift confidence, with its chairman promising to fulfil responsibilities, the markets are now looking to Beijing to stem the contagion.
What can we learn from Evergrande debt story?
As housing prices surge in other regions, the world can learn from China and past housing bubbles to prevent future crises. The World Economic Forum’s Emerging Horizons in Real Estate: An Industry Initiative on Asset Price Dynamic report suggests the following to help avoid future real estate asset bubbles:
- Market data: Regulatory authorities need to work with the real estate industry to deliver robust and timely market data, analysis and information, including data related to the financing of real estate investment and development, noting the global and national initiatives already under way.
- Transparency and understanding: National and international authorities should adopt targets for delivering enhanced transparency and understanding, broadly defined, across real estate markets and related markets for securities and derivatives.
- External policy impacts: The real estate industry should engage with governments and policy-makers at global, national and local levels about the impacts of public policies on the real estate sector.
- Information clearing house (“hub”): A platform should be established for tracking and communicating significant new policies and recent research to senior decision-makers in the real estate, banking and finance sectors, and to public-sector policy-makers to address areas like developments in the derivatives market and global and national banking sector reform.
- Emerging markets: Specific policy options are required by emerging market economies (EMEs); the World Economic Forum should provide its convening platform for addressing specific issues arising from asset price volatility in EMEs.
While it is still not clear what will happen to Evergrande in the coming days, the possible outcomes include bankruptcy, breakup, buy-out, or a bailout by the government. What is clear is that the world needs to closely monitor asset prices and debt levels to preserve the health of an already fragile global economy.
