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 since the company is China’s biggest property group and the world’s 112th largest company in terms of sales value. Now, the only possibility for the group to repay due interests on its US$300 billion debt is to set a high discount on its property assets and gather enough liquidity to avoid collapse.
At its peak three years ago, the Hong Kong-listed China Evergrande was the world’s most valuable real estate group. At the time, the company was expanding into New Energy Vehicle (NEV) manufacturing, even to the extent that it envisioned the takeover of Tesla in the Chinese market. Evergrande established joint ventures with European companies to reach this objective, such as a joint venture with the German company Hella for the production and development of a battery management system. The goal of the partnership was to upgrade the offer in the already booming Chinese NEV market. How is it that just a few months later, the situation has changed drastically? And what are the potential risks for European investments?
China’s real estate bubble
After the 2009 financial crisis, China’s economic rise has been tied to the booming infrastructure and property building sectors as its main drivers. In the last decade, local governments injected countless financial resources into real estate. This can be explained by the fact that revenue obtained from licenses for urban land is the main source of income for many local governments, especially because municipalities cannot levy taxes as the central government can, but still shoulder heavy public service provision responsibilities. The fiscal stimulus poured into real estate in 2009, coupled with the encouragement by local governments to spur property construction, led to a rise in land prices and, ultimately, housing prices in Chinese cities. This overheating property market represents a significant threat to economic and social stability in China.
In 2017 Xi Jinping identified reducing financial risk as one of the three crucial battles in China’s development. To better regulate the sector and avoid those distortions in the future, China aims to strengthen state control and supervision on credit provision to increase stability. This, coupled with higher-quality but likely slower economic growth, are two of the main objectives of the 14th five-year plan.
In the Evergrande case, observers are now closely following the situation to see 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 known that the government’s main interest is to avoid civil unrest and financial turmoil.
The ‘Three Red Lines’
The main trigger for the crisis of Evergrande seems to have been Beijing’s issuing of new rules on capital control in August last year. The new regulations are referred to as the “Three Red lines” and consist of parameters to which the country’s real estate developers must comply to have access to credit.
With liabilities as high as $300 billion, Evergrande was from the start likely to fail this test. Given the high indebtedness of Evergrande, it is easy to understand why credit rating agency S&P decided to rate the company to CC credit risk. A CC rating means that “a company or government 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 keep its business afloat was to start selling its properties at discount. Given these threatening forecasts, concerns arise of a potential crisis in China’s real estate sector, which could make Evergrande the “Lehman Brothers of China”.