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. Around the world, concerns arise about the company’s destiny and the repercussions that its default could cause worldwide.

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 the collapse. But there were times, not too long ago, in which the situation was different. At its peak, three years ago, the Hong Kong-listed China Evergrande was the world’s most valuable real estate group. At that time, the company was expanding into the New Energy Vehicle (NEV) manufacturing, even to the extent that it envisioned the takeover of Tesla in the national market. Evergrande established joint ventures with European companies to reach this objective. An example of this is represented by the 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 new vehicle market. How is it possible that just a few months after, the situation has changed so 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 coupled with infrastructure and property building boom as the main driver. In the last decade, local governments injected countless financial resources in real estate. The reason 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 do. The fiscal stimulus in real estate in 2009 coupled with the encouragement by local governments to spur property construction led to a rise in land 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 that reducing financial risk was 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 the state control and supervision on credit emission to grant stability. This coupled with a higher quality -but 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 bailouts request from the firm’s founder, it is well known that China’s government main interest is to avoid civil unrest and financial turmoil.

The ‘Three Red Lines’

The main trigger for the backdrop of Evergrande seems to have been Beijing’s issuing of new rules on capital control last year August.  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 wasn’t the best candidate for this kind of review. Given the high indebtedness of Evergrande, it is easy to understand why the S&P decided to rerate 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 on a potential crisis in China’s real estate sector, which could make Evergrande the “Lehman brothers of China”.

Risks for Europe

Over the past few days, many of Evergrande’s creditors and suppliers are gathering around the Evergrande headquarter asking for loans repayment. The central government is aware that a messy meltdown could cause credit polarization and thereby hurdles in access to financing for other companies.

On a higher level, the default of the company and its repercussion on the Chinese real estate industry could deeply affect the price of commodities worldwide. Director of the ECB, Christine Lagarde, states that “Europe has limited direct exposure to Evergrande’s debt crisis‘. She adds that at the moment they still see a China-centric impact and exposure. However, we see that the Guangdong-based Evergrande Group, a company with almost 30 subsidiaries, has, throughout the years, made huge investments in Europe, as showcased in our Sino-EU Foreign Direct Investment radar through which we tracked all Chinese acquisitions into the bloc. Examples can be seen at the acquisition of 69% of the Swedish NEVS, a global electric vehicle manufacturer and the 100% acquisition of the UK Protean Electric in 2019. But also European joint-ventures in China with Evergrande are at risk, for example the joint ventures with the German companies Hella and Hofer Powertrain. These investments are all at risk now that the default of Evergrande is coming closer.