Where did it all go wrong for Chinese property developer Evergrande?

This article was originally published by Business Leader magazine.

Funded in 1996 by Hui Ka Yan in the province of Guangzhou, Evergrande is one of China’s largest real estate developers, employing more than 200,000 employees (and indirectly sustaining more than 3 million jobs in related sectors), owning over 1,300 residential projects across more than 280 cities in China.

Despite being mainly known for its core activity within the residential property sector, the company’s diversified interests expand to include, among others: investment in electric cars, insurance, dairy products, beverages, a football club and theme parks.

As the Chinese economy and property market boomed over the last 30 years, so did Evergrande, by playing a significant role in the transformation of many rural areas in modern cities.

Struggling to pay its employees

Having funded its expansion and growth by borrowing heavily, the property giant, with more than $300 billion in outstanding debt, is now finding it difficult to pay its employees, suppliers, contractors, and investors. Additionally, more the 1.6 million flats are still unfinished and yet to be delivered to home buyers that have pre-paid.

After missing key payment to foreign investors on the 23rd, 29th of September and 11th October, and warning with a statement made in September that: “There is no guarantee that the group  will be able to meet its financial obligations”, it is now understood that Evergrande has made a last minute payment of $83.5m two weeks ago, and an additional one of $47.5m last week, just in time to avoid default before the expiration of the 30 days grace period.

It is still unclear, however, where the funds to make the payments in October came from, leaving investors and financial markets confused. Another key deadline is also approaching on the 11th of November, so it remains to be seen if this will be met by the giant developer and default avoided once again.

The late payments seem to corroborate the hypothesis that even if Evergrande collapses, which according to some analysts is now inevitable, the collapse will be a controlled one so that consequences for the Chinese estate market and economy (and beyond) can be restrained.

So what went wrong? 

How did Evergrande reach this point? The company has seen revenue from home sales decreasing (especially in smaller cities), and it has significantly suffered from the credit crunch due to the new regulations introduced by the Chinese Government.

In fact,  in the attempt to control the housing boom, tackle inequality and make real estate more affordable, and famously stating that: ‘Housing should be for living in, not for speculation’, Beijing has introduced the so-called ‘Three Red Lines’ rule, according to which, in order to access new credit, a property firm must satisfy the following three criteria: 1) The company’s proportion of assets financed via debt must not exceed 70% 2) The company’s net debt cannot be more than its shareholders’ funds 3) The company must have an amount of cash (or cash equivalent) to be able to pay all its short-term debt.

More specifically, if a company satisfies all the 3 criteria above, then the acceptable growth of debt is 15%. If only two criteria are met, then the acceptable growth of debt is 10%; if only one criteria is met, the permitted growth of debt is 5%; however if none of the criteria are met (which is Evergrande’s case), the permitted growth of debt is 0%. Differently from some of its competitors, Evergrande failed to address these stricter financial regulations, hence the impossibility to access new loans, proving its practice of financing expansion by debt unsustainable.

It’s not just Evergrande

Evergrande is not on its own, the tighter financial regulations and decrease in home sales (also due to Evergrande’s crisis) have affected other Chinese property developers, which have been recently downgraded by rating agencies such as Standard & Poor’s ( S&P). These companies are the following: Fantasia, China Properties Group, Modern Land, Sinic Holdings.

Since the housing market and related industries account for approximately 30% of China’s GDP, the collapse of a giant such as Evergrande would clearly impact the economic growth of China, however it is reasonable to assume that the collapse would be controlled and damaged limited.

Would the world economy feel the collapse of Evergrande?

Well, the short answer is yes. If China’s economy slows down, this will be felt by the rest of the world, considering the fact that China’s is the second largest economy in the world and considering the important role it plays in international trade.  However, it is also true that the pandemic has (or at least should have) prepared the other economies to rely less on China (remember the initial outbreak in February 2020?).  Will the world economy feel the collapse of Evergrande to the same extent as Lehman Brothers’ collapse in 2008? The short answer this time is no.

Even if the transmission mechanism via international trade is still relevant, since China is a key trade partner for major economies (as the US in 2008), it is also true that the transmission mechanism via financial markets is less likely to happen considering the fact that foreign investors are not exposed to Chinese financial markets as they were to that of the US, and considering the fact that the Chinese financial system is much more controlled than the US financial market in 2008.

Additionally, and this is a crucial difference, the debts of Chinese property developers are not related to financial instruments (i.e. they are not linked to derivatives, which are financial instruments whose value depends on underlying assets such as, for example, bonds). The problem with Lehman’s debt in 2008 was that, due to the complexity of financial instruments and lack of regulations, it was not clear where the toxic bonds were.