China's Real Estate Bubble: The Evergrande Crisis
Recently, China’s largest infrastructural and property developer has found itself in a Lehman like crisis, and has found no way to make payments on its bonds that it had raised for its aggressive expansion over the past few years. This event has seen by many as a distressing signal across the world, with global markets sent tumbling over fears of an expected economic meltdown that can badly affect the world, when the world is in a bad shape already. So, what exactly did happen here?
The Chinese developer Evergrande, is the second largest infrastructure and property developer of the country, which was seen as the company that allowed ‘working class families to afford apartments”, and is based out of the city of Guangzhou. Evergrande had ridden the wave of the optimistic real estate boom in the country, which allowed to establish itself across 280 cities, and becoming responsible for over 1,300 real estate development projects.
The Chinese economy depends heavily on infrastructural projects and developments for its economic growth; so much so that real estate contributes 30% towards the total GDP of the country. And since Evergrande is the second biggest developer in the country, it happily provided the said development, until it was caught unaware by the recent regulations introduced by the government.
In order to access funds to fuel its aggressive expansion requirements, Evergrande had issued bonds, a lot of bonds, and accumulated debts totaling up to $300 billion, in order to acquire assets and fuel expansion costs. Furthermore, since it is a property developer, it also owes up to a $103 billion to construction companies and other business creditors. Furthermore, the company also owes money to around 171 domestic banks and 120 financial firms.
So, what had prompted a change in the regulations established by the government? Over the years, the prices of real estate had been slowly rising in China, which had influenced the government to issue favourable regulations that allowed for the availability and subsequent borrowing of cheap credit to finance development costs and to not default on those which were already underway. And since companies like Evergrande had access to cheap credit, they went on a buying spree without any fears, since the horizon for redemption was very well coming over the time of the next few years, which meant enough time for them to expand and grow, and earn returns on their investments, which would therefore allow them to repay their massive debts.
And since land has only a limited capacity, there was an exponential increase in real estate prices. Therefore, in order to curb this artificial scarcity which was technically the government’s own doing, the new regulations in place limited the extent to which real estate developers could borrow funds, and a new time horizon for them to repay the interest and principle on their debts. Therefore, this sudden change in regulations meant that companies like Evergrande had to start paying back on their debts, but since the majority of the money had been spent on the expansion process, there was almost none of it left to allow companies to make repayments.
As a result, Evergrande started selling off its properties and developments for cents on the dollar so as to generate enough cash to repay its debts and not default on them. Furthermore, since they had already taken on so much debt from banks and financial institutions in the first place, none of them were willing to lend it more money to allow it to cover its interest payments. And since it was paying off its dues in the form of property, it meant that the company had lesser land available with itself to kick-start their developments for which they had already taken advance payments for.
All of this coalesced into one big final detonation. Since the company had no cash to pay off its debtors, and lesser amounts of property because of its unsuccessful attempts to pay them off anyway, it found itself between a rock and a hard place. This was not all, since the general public (who had already paid the down payments and deposits for the projects that were yet to start on the assets that the company had sold off to cover its debts) got to know about this, staged a mass protest outside their headquarters, and even went in to camp down for the next few days so as to put pressure on the company to pay them back those deposits.
The problem doesn’t stop anywhere near here, though. When the news of the company’s default hit the market, the markets around the world tumbled. The NASDAQ composite fell by a 2.2% in a single day, with the VIX, nicknamed the “Fear Gauge” of Wall Street, at an all time high of 28.8 since May, before sliding back to 25.7.
This does not even stop here now. Since the Chinese government had introduced the regulations to decrease reliance on debt, it has now been made abundantly clear that the checks that were carried out before the advancement of loans to Evergrande were not enough in quality or magnitude. Furthermore, since the company had significant holdings in Blackrock, HBSC Holdings, as well as pending dues to their creditors (of which the majority are banks), there are concerns over a massive cash crunch that shall take place within the Chinese economy, and in that of neighbouring countries. Additionally, the company’s bonds worth $4.7 billion due for repayment in 2025 started trading for 80 cents on the dollar over fears of the company’s current prospects.
This entire event has been dubbed by many as China’s “Lehman moment”, which refers to the fall of the Lehman Brothers during the CDO crisis during 2008-10. However, some feel that this comment is rather off the mark, and state the company’s debt is well collateralized, and all this fuss and scare is just a tremor in the markets worldwide, that shall soon come to pass. Since many are speculating over the possibility of a bailout by the Chinese government, it remains to be seen as to what happens to the company and its future.