What is the Evergrande debt crisis and why does it matter for the global economy?

This article was updated on 26 October 2021.

The news that Evergrande, the world’s most indebted real estate company, was on the brink of collapse sent global markets tumbling last month. The company had warned investors that it could default on its debts and ratings agency Fitch had said that default ‘appears probable’ while Moody’s, had said ‘Evergrande is out of cash and time’.

An unexpected green shoot appeared last week in the otherwise barren outlook for Evergrande’s debt crisis, as the real estate developer managed to remit $83 million for a key offshore bond payment. The company has also posted photos of construction resuming on some of its projects in Guangdong province, which had been halted due to the developer’s financial woes. This positive turn of events came just on the heels of the foiled deal with Hopson Development Holdings for the rival to buy half of Evergrande’s service unit.

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?

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.

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.

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.

Evergrande is not the only Chinese developer in trouble. China Properties Group recently defaulted on $226 worth of notes, while Modern Land asked investors for extra time to pay a $250 million bond due on October 25, Sinic Holdings advised that it likely would default on some of its $250 million bond payments and Fitch downgraded Sinic Holdings rating to a C and Fantasia failed to pay $315 million owed to lenders, comprising $206 bond repayment and a $109 million from Country Garden, China’s second largest property developer. In late October, Moody’s downgraded seven major Chinese real estate companies due to dismal sales and financial projections. A recent prediction from Nomura Holdings, suggests China’s real estate sector is more than $5 trillion in debt.

China’s real estate market accounts for a whopping 30% of the country’s GDP, 41% of the Chinese banking system’s assets are either directly or indirectly associated with the property sector and 78% of the invested wealth of urban Chinese is in residential property. To quell fears of contagion across China’s real estate market, Beijing has pledged to prevent downstream impacts on other real estate companies in the region. There remains, however, great uncertainty as to whether the Government will step in to support Evergrande itself in the event of a default.

Chinese policymakers have continued their efforts to reign in speculatory behavior and over-leverage, recently introducing a proposal to levy taxes on both commercial and residential property. The move, which would be transformative to the economy, would help provide the government with an alternative revenue stream to land sales, which have contributed to the overheating.

The situation in China is a potential canary in the coal mine as housing prices have been surging across major global markets. According to UBS’s Global Real Estate Bubble Index, which ranks cities based on their residential property prices as either “bubble risk”, “overvalued”, “fair-valued” or “undervalued”. Of the 25 cities included, 21 are either a bubble risk or overvalued. Frankfurt, Toronto, and Hong Kong top the list as having the highest bubble risk, followed by Munich, Zurich, Vancouver, Stockholm, Amsterdam and Paris. All US Cities on the list were also ranked as “overvalued”.

Investors are keeping a close eye on Evergrande and Beijing as the future remains uncertain for China’s property market. Globally, as markets contend with rising inflation and potential rate hikes as a result, prices may begin to cool off.

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:

While it is still not clear what will happen to Evergrande, 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.