Evergrande's mountain of debt and potential risks for Europe

Chinese real estate giant Evergrande is now officially the world's most indebted real estate developer. Concerns are on the rise globally about the company's future and the repercussions that its default could cause. These concerns are well-grounded: Evergrande is China's biggest property group, with a significant sales value and US$300 billion in debt. The only possibility for the group to repay due interest is to set heavy discounts on its property assets and gather enough liquidity to avoid collapse.

In 2018, Hong Kong-listed China Evergrande had its peak as the world's most valuable real estate group. At the time, the company was expanding into New Energy Vehicle (NEV) manufacturing, even envisioning the takeover of Tesla in the Chinese market. Evergrande established joint ventures with European companies to reach this objective — including a joint venture with German company Hella for the production and development of a battery management system. Just a few months later, the situation changed drastically. What happened, and what are the potential risks for European investments?

China's Real Estate Bubble

After the 2009 financial crisis, China's economic rise was tied to booming infrastructure and property construction as its main drivers. In the last decade, local governments injected vast financial resources into real estate — primarily because revenue from urban land licences is the main income source for many municipalities, which cannot levy taxes as the central government can but still shoulder heavy public service responsibilities. The fiscal stimulus of 2009, coupled with local government encouragement of property construction, led to rising land prices and ultimately soaring housing prices across Chinese cities — an overheating property market that represents a significant threat to economic and social stability.

In 2017, Xi Jinping identified reducing financial risk as one of three crucial battles in China's development. To better regulate the sector, China aims to strengthen state control over credit provision. This, alongside higher-quality but likely slower economic growth, are two of the main objectives of the 14th five-year plan.

Observers are now closely watching whether the Chinese government will intervene to prevent a default or allow Evergrande's creditors to suffer major losses. Even though authorities in Guangdong have already rejected a bailout request from the firm's founder, it is well understood that the government's main interest is to avoid civil unrest and financial turmoil.

The Three Red Lines

The main trigger for Evergrande's crisis appears to have been Beijing's issuing of new rules on capital control in August 2020. These regulations — referred to as the "Three Red Lines" — consist of parameters that China's real estate developers must comply with to access credit. With liabilities as high as $300 billion, Evergrande was from the start likely to fail this test. Credit rating agency S&P duly rated the company CC — meaning it is "very vulnerable to adverse economic conditions and has a sizeable chance of defaulting on its debts at short notice."

Under these circumstances, the only possibility left for Evergrande to stay afloat was to begin selling properties at a discount. These threatening forecasts have raised concerns of a potential crisis in China's real estate sector — one that could make Evergrande the "Lehman Brothers of China."

Risks for Europe

Many of Evergrande's creditors and suppliers have been closing in on its Shenzhen headquarters demanding loan repayments. The central government is aware that a disorderly meltdown could cause credit polarisation and hinder financing access for other companies. At a higher level, the company's default and its repercussions on the Chinese real estate industry could deeply affect commodity prices worldwide. European Central Bank Director Christine Lagarde has stated that "Europe has limited direct exposure to Evergrande's debt crisis" — adding that the ECB currently sees a China-centric impact.

However, Guangdong-based Evergrande Group — a company with almost 30 subsidiaries — has made significant investments in Europe over the years, as tracked through Datenna's Sino-EU Foreign Direct Investment radar. Examples include the acquisition of 69% of Swedish NEVS, a global electric vehicle manufacturer, and the 100% acquisition of UK Protean Electric in 2019. European joint ventures in China with Evergrande are also at risk, including those established with German companies Hella and Hofer Powertrain.