Is China approaching its Lehman moment? The Evergrande crisis is a growing threat

China Evergrande Crisis

Real estate giant Evergrande’s crisis is getting worse for days. The shares of the Chinese firm have plunged more than 10% on the Hong Kong Stock Exchange to fall to 2.28 Hong Kong dollars, dragging the stock markets around the world. With the recent slide, the stock price has tumbled more than 80% in the last year, a drop that puts Evergrande’s future in more than doubt. A disorderly restructuring or a liquidation of the firm would create a shock wave that would damage the solvency of part of the Chinese financial system and would end up hitting the entire economy of the ‘Asian giant’.

Worse, if China’s growth slows sharply as a result of this debt crisis, the rest of the world may end up being indirectly impacted as well, as Beijing is the world’s largest importer of raw materials and one of the world’s largest commodities. of the largest players in international trade. Furthermore, China’s GDP already accounts for almost 18% of the entire world economy. For now, what seems clear is that Evergrande is facing a ‘credit event’ on the scope of which will depend on the ultimate impact on the world’s Chinese economy.

Although the baseline scenario for most experts and analysts remains an orderly restructuring, with limited impact on the markets and the Chinese economy, with each passing day, these same experts acknowledge in their reports and statements that risk is increasing. China could be approaching its time Lehman Brothers (the bankruptcy of the North American bank in 2008 that exacerbated the financial crisis).

If the authorities let this real estate giant fall, its collapse has the potential to affect the rest of the firms in the sector (developers, agencies…) and construction, the financial sector and, ultimately, the real economy, which you are already losing strength naturally. From Societe Generale they give this scenario a probability of 30%. “A hard landing for China”.

Evergrande’s liabilities reach 250,000 million euros. The risk of a domino effect on other developers and firms in the sector is on the rise and could be very dangerous due to the large size of China’s real estate sector. According to data from the investment bank Nomura, the debt of Chinese developers was about 33.5 trillion yuan (4.4 trillion euros) at the end of the second quarter of 2021. On the other hand, China’s home mortgage loans totaled 36.6 trillion yuan (4.8 trillion euros) at the end of the second quarter of 2021, 13% more than at the end of the second quarter of 2020. To put these figures in perspective, China’s nominal GDP in 2020 It was 101.6 trillion yuan (about 13.4 trillion euros).

Will Evergrande be the first great piece to fall from the domino? This week is key and can provide important clues about the outcome of the real estate giant’s crisis. Evergrande bondholders are close to finding out if the real estate giant’s liquidity crisis is as bad as it sounds. The date for the payment of interest on two notes of the firm is due this Thursday, according to data from Bloomberg. This moment will be key in determining whether the real estate giant will continue to meet its obligations with most bondholders, despite having already announced a delay in payments to banks, suppliers and other domestic bondholders.

Investors are valuing default with a high probability: the notes are trading at less than 30% of their face value. Evergrande’s payments due Thursday include $83.5 million in interest on an 8.25% five-year dollar bond, data compiled by Bloomberg shows. There is a 30-day period before a late payment is considered a default or partial default. On the other hand, Evergrande must pay a 232 million yuan ($36 million) coupon on a domestic or national bond on the same day. In total, Evergrande has to face $669 million in coupon payments due until the end of this year. Around 615 million are in dollar bonds, as shown by data compiled by Bloomberg.

Wei Yao and Michelle Lam, economists at Societe Generale, explain that this “is a critical time for reform-minded politicians in China. Evergrande, one of the largest (and also most leveraged) real estate companies in China, is on the verge of a painful debt restructuring… For now we believe policy makers will help coordinate debt restructuring and reduce deleveraging to avoid a hard landing, but they will not abandon reforms entirely.” This means that while Evergrande could receive some help, there will be investors and other players involved who will also pay ‘dear’ for the restructuring.

Lehman moment in China?

“Therefore, a Lehman-style collapse of financial markets is not our main forecast, what seems more likely is a prolonged and severe economic slowdown. However, this may be a necessary pain in the short term to support sustainability. of the economy in the long term”, assure the experts of Societe Generale.

From the Swiss bank UBS they agree: “A credit event (it can range from a total bankruptcy to a simple non-payment of interest) seems inevitable right now in our base scenario, how it extends or not to other markets will depend on whether Evergrande restructures its debt or fully liquidated. To this day, we remain confident that the former is a much more likely outcome… In the event of a restructuring, we expect bonds (prices) to rebound from their lows and contagion to be limited, but in the case of a full liquidation, you could see a high degree of contagion through several key channels.”

What if there is a total liquidation?

A full sell-off would lead to a material loss of investor confidence in the real estate sector in general and in the Asian high yield market, which “would create a spillover effect to Chinese financial assets in general”.

The second channel is through the dreaded ‘domino effect’, say UBS experts. “A domino effect would create various credit events, as both banks and non-banks with large exposures to Evergrande could potentially go under or be forced to restructure. This, like the previous channel, would again create a spill-over effect or spill onto other Chinese financial assets.”

Although this scenario still seems avoidable, with each passing day the situation becomes more dangerous. “We recognize that downside risks are increasing. In our risk scenario, several things could happen,” say the economists at Societe General. For example, Yao and Lam talk about the possibility of a widespread and disorderly debt restructuring process in Evergrande that causes a large impact on the real estate sector, damaging financing conditions and putting immense downward pressures on investment, home prices and sales nationwide.

This risk scenario also hypothesizes that policy makers will be reluctant and slow to intervene in Evergrande’s deleveraging process, leading to a disorderly restructuring and decimating investor confidence in Chinese companies. “If so, sales and investments in housing would experience an absolute contraction during the next year, and the economy could experience a hard landing. For now, we attribute a 30% probability to this gloomy scenario,” they assure from Societe Generale.

The importance of real estate in China

The real estate sector is the largest contributor to China’s GDP. Based on 2020 data, Nomura estimates that the real estate sector contributed 12.3% to China’s GDP according to our strictest measure and up to 16.4% according to the broadest method.

If you add the government land sales revenue paid by developers, the total contribution from the real estate sector amounts to about a quarter of China’s GDP. “The importance of the real estate sector for public revenue is even more significant; we estimate that the real estate sector contributed 24% to total tax revenue in 2020 and, more generally, contributed 44.0% to total revenue of the government”, they maintain from Nomura.

Taken together, the slowdown in new home sales volumes and investment in property construction (in real terms) may directly affect real GDP growth in the second half by subtracting 4.4 percentage points.