Evergrande is a Lehman-style lesson for China
gGlobal markets faced a massive selloff on Monday as investors feared the collapse of a major Chinese real estate company could spill over into the financial stability of the world’s second largest economy.
A large real estate developer in China, Evergrande, which has unusually large debt, is in financial difficulty following the government’s efforts to cool a booming real estate market. Concerns about the company’s sustainability escalated after rating firm S&P Global Ratings said in a report this week that the company was set to default on its debts as early as Thursday.
Investors fear that Evergrande may be a sign of wider problems in the Chinese real estate market, which is showing signs of a bubble – economic jargon for when asset prices have risen sharply and reached a level that seems unsustainable. The bursting of these bubbles has an effect often referred to as a crash: a sharp and sudden drop in asset prices.
This is of great concern to investors who are exposed to Chinese assets but also to the global economy, given the relative size of China. The country is expected to account for one-fifth of global growth from 2021 to 2026 according to forecasts released by the lender of last resort, the International Monetary Fund, in April this year.
The woes of real estate companies were particularly alarming as the real estate sector represents a significant part of China’s economic output. Investment in real estate accounts for 13% of China’s GDP according to the Bureau of Economic Analysis of the United States Department of Commerce in 2018. Historically, this compares to investment in real estate accounting for around 5% of GDP in the United States.
In 2020, economists Ken Rogoff and Yuanchen Yang calculated that a 20% drop in housing sector activity could lead to a 5-10% drop in GDP.
Some economists and market analysts vehemently doubt this is a repeat of the 2008 financial crisis, but that doesn’t mean it isn’t a signal of serious problems ahead. A bumpy ride, or even a crash in China’s overcooked construction and real estate market, would accelerate a slowdown in the country that has already failed to bounce back from the pandemic as quickly as some predictions suggest.
It is not yet clear what action the Chinese government will take, but its central bank has already stepped in to increase liquidity, ensuring that liquidity can continue to flow through the financial system, in a signal it may have tried to calm down. the nerves of investors and bankers.
If Evergrande defaults, the pain will be felt by the large financial firms and banks that first hold company-related assets, said Tommy Wu, chief economist for the Asia-Pacific region at Oxford Economics. The independent.
“There are different stakeholders for the Evergrande situation. There are homeowners who bought houses in Evergrande, there are retail investors who bought products in Evergrande, the other stakeholders would be banks, bondholders and suppliers, ”Wu said.
The top priority, as far as the Beijing government is concerned, is to mitigate the impact of the potential fall of Evergrande on homeowners, Wu added. But for the rest of the world, the question Wu and Other economists are debating is whether government intervention succeeds in stopping a broader “fire sale” in China’s real estate sector.
S&P believes the Chinese government will only step in if there are signs of wider contagion “failing several large developers and posing systemic risks to the economy”, rather than if the impact is confined to Evergrande alone.
“We believe the government will organize a managed restructuring, even if it will not bail out Evergrande and investors,” Wu said.
Some economists stop long before they call it China’s “Lehman Moment” – the US bank whose collapse heralded greater financial turmoil in the financial crisis. Such a narrative is “irrelevant,” according to Simon MacAdam, senior global economist at Capital Economics. While any situation involving debt and property brings troubling memories to investors, it is a different type of problem in a different type of market.
“The closest parallel is the [South] Korea in 2003, rather than Lehman, ”said Freya Beamish, chief economist for Asia at Pantheon Macroeconomics. The independent. “The ultimate difference is from a global perspective: China is not at the center of the global financial system, whereas the United States was and is. “
In South Korea, ccredit card loans exploded in the late 90s and early 2000s. This has shifted households from determined savers to spending and accumulating debt. Credit card purchases as a percentage of consumption increased from 15.5% to 24.5% between 1999 and 2002.
The parallel is important because China faces a complex web of financial leverage created by a boom in its real estate sector, Ms. Beamish said. It will take time to unravel and may even prove impossible to measure over time.
Excess savings, a problem in South Korea in the late 1990s and a well-documented problem in China, which has had one of the highest savings-to-GDP ratios in the world in recent years , can help fuel bubbles, according to some economists. , including former US Federal Reserve Chairman Ben Bernanke. He believes that the glut of global savings accumulated in 1996-2006 helped fuel the financial crisis of 2007.
Beamish believes a similar effect may have occurred in China in recent years, where a wall of money-hungry businesses has collided with another wall of money built from household savings. The result: a real estate and construction bubble.
“In that sense, the driving force behind these Evergrande woes is the same as the current Lehman, but China and the United States have very different roles in the global financial system, so the outcome will not be parallel.”
“For the real economy, the threat is that there will be an acceleration in fire sales not only by Evergrande but other real estate developers. These guys have been evergreen for a long time. It’s an endemic phenomenon in the real estate industry, ”said Beamish. Everreening is often used in finance to describe companies that avoid default by taking on more debt.
“It all looks like a Ponzi scheme. The concern is that the Chinese authorities are not doing enough at first to properly stop this, because they cannot quantify the problem, because it is such a complex network, ”she added. This lack of clear statistics as to who, exactly, is exposed to what in the Chinese real estate industry is another reminder of the confusion after the Lehman collapse.
If, as Beamish and others expect, Beijing steps in quickly to try to mitigate and slow any wider deterioration in the real estate sector, it may lessen the impact of greater confidence in financial markets, by stopping large-scale fire sales in the real estate market and “nasty” on household finances, she said.
The Evergrande situation is not ultimately a sign of a financial meltdown in China for the wider financial system, but there are some fallout here to consider.
“In terms of contagion, I think it’s mainly a Chinese problem,” Wu said, but commodity prices, for products like steel, iron ore, and coal, are likely to rise. be affected by a slowdown in Chinese construction, he said. Even if government interventions with a boost for infrastructure construction could mitigate this somewhat.
Banks such as HSBC and Standard Chartered, which derive large sums from trade finance linked to Chinese imports and exports, or other Chinese assets, could also be hit by a larger economic slowdown in the coming months.
And while Evergrande is not at the center of global financial markets like Lehman was, its potential fall is a symptom of a broader concern. Even if a crisis is averted – thanks to a state-led restructuring of Evergrande – Chinese construction is in decline, MacAdams said, slowing China’s GDP growth to 2% by 2030 according to him. It is also, as Lehman was, symptomatic of a savings glut and subsequent bubble.
Put simply, Wu said, “It makes the outlook a little darker now.”