When the music stops...
When the music stops…
A major Chinese property group called ‘Evergrande’ is on the brink of failure. They are sinking in over $500 billion of debt.
To put that into perspective, the Australian economy as a whole has a GDP of around $1.9 trillion. You’re talking about one company that has liabilities to the value of about 26% of the entire Australian economy as a whole.
This company is bloody HUGE!
However, to put it into perspective China’s economy as a whole is worth $20 trillion, so while $500 billion for us is a massive number – and it is in China too - it’s not of the same magnitude.
If Evergrande is “allowed” to crash, it could trigger a collapse in China’s property market. There are reports that the crisis is spreading to the rest of the property sector, with several companies defaulting in recent weeks.
Fantasia, Sinc and China Properties Group are among the other developers to have failed to meet payments. Many experts are worried that contagion in the property sector could knock out a key engine of Chinese growth.
How Big Is The Chinese Property Market?
To put the Chinese residential property market into perspective, the Australian residential property market is estimated to be valued at $9.1 trillion. This is comparative to the Chinese residential property market which is estimated to be in excess of $74 trillion.
When looking at the size of China’s property market, China’s real estate & associated industries are said to make up a third of China’s economy.
Why
The company’s problems are in part due to the recent government crackdown, real estate prices have been rising for years, with the Government imposing new regulations (the three red lines) to try and slow the growth.
The three red lines are a set of thresholds on three financial ratios,
Liabilities to Total Assets of less than 70%
Net Debt to Equity of less than 100%
Cash to Short-Term Debt of more than 1x
To put simply, the Chinese Government wants their property developers to be less leveraged and have more cash available to cover their debt and interest obligations. The belief was that these measures would help in cooling the rapid growth within the property market.
This crackdown has stemmed from the top.
“Housing is for living, not for speculation”
- Xi Jinping President of the People’s Republic of China
Who
Evergrande is one of the biggest residential property development groups in China.
They are ranked 122nd on the Fortune Global 500
1300+ projects in over 200 cities across China
Employs over 200,000 people
Has land to build over 50,000 acres of floor space
They have helped make home-ownership a relativity for millions of Chinese citizens
Over 1.5 million people have put deposits on new homes that have yet to be built.
How
“When the music stopped” the pyramid scheme came crashing down.
For many years, Chinese property developers have operated on extreme leverage that would long ago blown them up anywhere else
Typically, property developers operate on a leverage ratio of around 20%. In China, that average is much higher, with many of the largest operating at 80% and higher.
For a lot of years the Chinese policymakers allowed this extreme leverage because they knew that China needed a lot of new houses for the national urbanisation program.
But that day has now passed and the Government has instead installed what is called the “three red lines” policy to force property developers leverage to fall.
With this amount of debt, it leaves the property developers very vulnerable to any kind of shock.
And that is exactly what happened when the music stopped. It was a perfect storm with the “three red lines” legalisation coupled with the global pandemic that put a stop to property sales.
Chinese property developers move so fast and have so much inventory of land and empty apartments, that any hiccup in their funding models leads to stressed sales.
This is where we are today. Chinese developers had the first hiccup during the global pandemic, which stopped sales. This stopped their entire system. Which resulted in their cashflow taking a massive hit and resulting in not having sufficient cashflow to meet debt obligations. These defaults resulted in a loss to access their offshore funding markets as investors wonder who is the next Evergrande.
And the poor publicity that has engendered has now crashed demand from the Chinese people.
Chinese developers are now in a pickle, as denied funding leads to stressed sales and falling prices which leads to more falling sales and stress.
Evergrande has $500 billion of debt.
The problem is their net operating cashflow is $5.4 billion which doesn’t cover its current interest repayments of $7.4 billion, because banks no longer just want interest repayments, they want their outstanding loans to be repaid and contractors and creditors have also claimed their cash at the same time.
Evergrande’s dependence on trusts and other asset management products began growing after banks were directed to cut back on their lending to the property sector.
Hundreds of thousands of Chinese households who bought high-yield investments risk being sucked into the spectacular unravelling of Evergrande after the developer missed payments on funds sold through shadow banks, which funnelled billions into its construction projects.
Some of these trusts, have already dipped into their own pockets to repay wealthy investors on Evergrande’s behalf, according to people familiar with the matter.
Evergrande has already missed payments on $8.4 billion of wealth products sold by Evergrande itself to retail investors which have sparked nationwide protests, putting more pressure
Contagion into the $4 trillion trust industry will put at risk many more investors, while also threatening the biggest source of non-bank funding for the property sector as shadow banks retreat.
By the end of 2019, Evergrande had done business with most of the 68 trust companies in China, which accounted for 41% of its financing, based on the last borrowing disclosure.
Despite this, trusts remain Evergrande’s biggest source of direct debt, outweighing bank borrowings and bonds.
When trusts began pulling back, the developer started squeezing money from more murky sources, selling its own high-yield wealth products to staff, home-buyers and others.
Two months later, angry employees and investors joined protests after the developer failed to make payments on the products, some of which offered yields as high as 10%
“Even if I go home now, I can’t sleep or eat.” - Mr Hu, Evergrande Investor – hardware factory worker, attending a recent protest.
Foreign investors worry that if Evergrande fails, they’ll be ranked low on the list of creditors when it comes to claiming any of the company’s assets.
And foreign investors’ anxiety about their exposure to the Chinese real estate market was exacerbated recently when a Chinese property developer, Fantasia, which specialises in high end residential projects and luxury apartments, failed to repay a $275 million five year bond that matured recently.
And by all reports, foreign investors have something to be anxious about. The Chinese Government has stated that the first obligation is going to make sure that homeowners who bought those homes take delivery and are made whole. At the very end of the pecking order are offshore bondholders.
The firm was also subject to heightened restrictions on its bank accounts as regulators ensured it used cash to complete housing projects and not to pay creditors.
READ THAT AGAIN!
The government has taken control of bank accounts to ensure housing projects are complete and cash is not used to pay creditors.
The growing concern has led US Secretary of State Antony Bliken to give an alarming assessment of the Chinese property debt fiasco, warning the downfall could affect “literally the entire world.”
This is namely due to the fact that economies across the world are so intertwined.
This is illustrated through Evergrande’s debt.
Evergrande reportedly owes money to around 171 domestic banks and 121 global financial firms.
This highlights that the financial fallout would be far reaching.
Iron ore price
How does this affect you & Australia?
Experts warn Australian exports will be particularly affected given China’s real estate industry is unlikely to experience another boom any time soon.
1. Lower Demand for Iron Ore
As things stand, experts are predicting Chinese construction is likely to fall 25% over the next and that equals roughly 200m tonnes of less steel that will be needed. That is a staggering 300m tonnes of iron ore equivalent.
We have already seen a 60% drop in iron ore prices. And this puts iron ore on track to match its 2015 price crash to somewhere below $50 in the neat future.
In addition, Australia has been protected by the unexpected energy crisis that has driven coal and LNG prices wild in Asia. But these are very short-term in nature. China has already commissioned oodles of new coal mines to resolve the issue by northern spring. So Coal prices will crash just like iron ore before very long.
That means there is a gigantic income shock is headed to Australia. Just as the RBA and APRA are tightening credit availability for our own property market.
This is called a pro-cyclical policy error, and if it transpires, will knock the stuffing out of our own property price boom.
2. Overall Weakening of China’s Economy
Beyond the direct effects, problems in China’s real estate and financial sectors could ripple across China’s economy, hurting demand for other goods and services in which Australia is a major provider.
To put trade with China in context, Australia’s exports to China are about three times those of our second most valuable market, Japan. Even with iron ore exports removed from the equation, China is still our biggest export market.
The effect of China buying less from Australia has been a matter of considerable debate. Some have argued Australia can compensate by diversifying into other markets. But such things take time.
3. Global Contagion
Evergrande’s debt crisis has echoes of the case of Lehman Brothers, the US investment bank whose bankruptcy in 2008 played a big part in precipitating the Global Financial Crisis.
Although most of Evergrande’s debt is localised in China, in financial and real estate sectors there is always a risk of investors and banks in other markets getting spooked, leading to a credit crunch throughout global markets.
The financial fallout would be far reaching. Evergrande reportedly owes money to around 171 domestic banks and 121 global financial firms.
If Evergrande defaults, banks and other lenders may be forced to lend less.
This could lead to what is known as a credit crunch, when companies struggle to borrow money at affordable rates.
A credit crunch would be very bad news for the world's second largest economy, because companies that can't borrow find it difficult to grow, and in some cases are unable to continue operating.
Australian share markets have already fallen off their highs over the past few weeks, certainly in part over concerns about China’s economy. The mining sector has experienced the real carnage, but there are indicators of general unease in falls across all sectors.
This will see continued volatility for the Australian Share market and subsequently your superannuation returns.
4. Australian Property Market
The effect on the Australian property market from the collapse of Evergrande is linked two-fold: both in terms of the price of raw materials to our construction sector, already rattled by Covid, and also in the inner city real estate market which is so dependent on Chinese migrants, in particularly university students, for tenants.
Will the Chinese Government let these property developers go under?
Without external help Evergrande has a very high likelihood of failure.
All the signs are there.
It is averting bankruptcy by servicing the interest payments on its massive debt by selling assets at unfavourable prices. They are currently in the mist of an enormous “fire sale”
All eyes are now on the Chinese government as a potential saviour through some form of debt restructure or guarantees.
However, so far the Chinese government has not committed itself, and it has taken a strong stance against high debt developers.
Some form of intervention to stabilise the situation seems more likely than not.
With many experts believing there is a slim chance Beijing would allow such a behemoth to go under. As many believe it would undermine the regime’s stability.
However, there are contrary opinions ….
Yun Jiang, managing editor at the School of Regulation and Global Governance at the Australian National University, believes the Chinese Communist Party is still debating whether to let Evergrande collapse.
"I'm looking for how the government will try to help the investors and the customers of Evergrande, without creating a moral hazard," she says.
Moral hazard is created, Jiang adds, when a government authority financially supports a company in financial distress as a result of reckless behaviour.
"We know the Chinese government has been focusing on the initial debt and doesn't want companies to continue to accumulate debt," she says.
"The other companies and investors will think certain companies are too big to fail and that is not good for the future of debt accumulation in China.”
Furthermore, in a recent post on China's chat app and social media platform WeChat, the influential editor-in-chief of state-backed Global Times newspaper Hu Xijin said Evergrande should not rely on a government bailout and instead needs to save itself.
This also aligns with Beijing's aim to rein in corporate debt, which means that such a high profile bailout could be seen as setting a bad example.
“When China sneezes, Australia catches a cold (or COVID)”
Sources:
https://www.abc.net.au/news/2021-10-08/chinese-property-evergrande-collapse-damage-in-australia/100521564
https://www.abc.net.au/news/2021-10-21/china-evergrande-formal-default-looms-beijing-contains-crisis/100550502
https://fortune.com/2021/10/05/evergrande-collapse-debt-xi-jinping-china-economy-eswar-prasad/
https://www.bbc.com/news/business-58579833
https://www.reuters.com/world/china/china-evergrande-shares-set-slide-105-after-26-bln-deal-collapses-2021-10-21/
https://www.brokernews.com.au/news/breaking-news/how-the-collapse-of-evergrande-could-impact-the-australias-property-market-278759.aspx
https://au.finance.yahoo.com/news/how-would-an-evergrande-collapse-impact-australia-013546908.html?guce_referrer=ahr0chm6ly93d3cuz29vz2xllmnvbs8&guce_referrer_sig=aqaaadsfrjj_hxvofgmukntdrraljhcwt4pckjd32jmhw0qya3dnmzj1c_7tt3jydhijksaslhnyauwnzyhpsfjzp1zh6aqhlaa5-3ihmjuon-hsi6jeluglwqlwcvkkw08jgsw8jf0itkbecuzdkzdr8n8fd6pgubcsov4rnnswafbc
https://www.afr.com/companies/financial-services/why-australia-will-bear-the-brunt-of-china-s-property-blues-20210926-p58usx
https://theconversation.com/3-ways-the-collapse-of-evergrande-will-hurt-the-australian-economy-168852#:~:text=Lower%20demand%20for%20iron%20ore,throughout%20China's%20real%20estate%20market.&text=About%2060%25%20of%20that%20iron,the%202020%2D2021%20financial%20year.
https://www.afr.com/property/residential/evergrande-pain-spreads-to-investors-as-more-payments-missed-20211012-p58zcf
https://www.afr.com/companies/financial-services/can-china-contain-the-evergrande-crisis-20211010-p58yod
https://www.afr.com/property/commercial/how-evergrande-s-rags-to-riches-founder-is-trying-to-save-his-empire-20211011-p58yyp
https://www.afr.com/world/asia/evergrande-crisis-is-shaking-china-s-growth-fault-line-20211011-p58z3r
https://www.reuters.com/world/china/china-evergrande-sends-funds-trustee-bond-coupon-due-sept-23-source-2021-10-22/
https://www.ubs.com/global/en/asset-management/insights/china/2021/china-three-red-lines.html