Evergrade And The Domino Effect

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How did China manage to make a dent in the market with this one property developer, invoking fear into investors’ minds? On monday, the news of Evergrande’s situation sent shockwaves into the markets and investing world. While this was an inevitability to the people who are scoped into the situation, let’s explore how it happened.

One of the main reasons is because Evergrande Group defaulted on its debt and it could not pay back the investors, suppliers, contractors etc. With debt racking over 300 billion USD. The start of the crisis began when the Chinese government started tightening leverage restrictions on its exuberant property market, followed by the sudden increase in construction material costs due to global inflation and supply shortages which was further exacerbated by the pandemic. Chinese property developers have thin profit margins and are highly leveraged, so any surprise increases to supply prices make it nearly impossible for them to break even. Evergrande’s lack of liquidity to pay suppliers, contractors, and debt investors got so out of control that they decided to offer physical assets instead of cash (unfinished apartments). This led to the company’s credit risk tolerance to crash and many legal cases being brought to Evergarnde by individuals and other companies. This situation has reminded investors of the 07/08 financial crisis. This is one of the reasons why the market dropped when it opened on Monday. 

Real estate has been the go to investment for Chinese investors mainly due to cultural reasons. It’s a custom that men in China should own a home before they are married. However, this has caused skyrocket increases in property valuations with an estimated average price to income ratio of 27x, whilst comparing to the US with a price to income ratio of 4x. And in the UK, the average price to income ratio being 8.35 in Q3 2019. 

This makes real estate a big business in China as most individuals’ wealth is in real estate. As property prices start declining the People Bank of China (PBOC) quickly reacts by lowering bank reserves boosting liquidity, artificially keeping the prices at the same level or higher. As most individuals’ wealth is in property, most of the country’s wealth depends on the property market, so the government has been quick to relax the banking learning requirements allowing developers and homebuyers access to more capital, keeping consumer confidence high. A big down side to this however is that many investors now believe (falsely)  that the housing market will never collapse not realising that the capital leniency has created debt growth.

The government will do what it needs to do, but anything that it does only exacerbates the situation. The debt is significant enough that it can cause hyper inflation if the PBOC acts in a reckless manner.

Personally, I believe that the Chinese government can do very little other than accepting the bubble and not kicking the can down further than it already has. I don’t think the Chinese government can help Evergrande escape this situation with a bailout of over 300billion USD. I guess it’s going to have to sink a little bit more or completely. Only time will tell the outcome of this crisis.

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