Why we should be concerned about the collapse of Evergrande

Over the last two weeks the most common financial question I’ve been asked is “why should I be concerned about the collapse of Evergrande?”

My first response is to remind people of the old Lehman Brothers investment bank in the US. It collapsed in 2007 and started the financial dominoes falling which led to the Global Financial Crisis.

Some experts are comparing Evergrande to Lehman Brothers and are predicting a similar collapse. I’m not sure about that. I don’t know whether it’s true or not, but it’s worth keeping an eye on the situation and understanding what’s happening.

Commsec chief economist, Craig James, issued a great analysis and explanation of the Evergrande issues this week. So let me try and explain it.

What is Evergrande?

Evergrande Group was founded in 1996 in Guangzhou, China. The company is a diverse conglomerate focusing on wealth management, food manufacturing, electric vehicle production, sports and theme parks, and property development.

In fact, the source of its troubles – Evergrande Real Estate – reportedly owns around 1,300 projects across 280 cities in China.

Evergrande is listed on the Hong Kong Hang Seng Stock Exchange and is based in Shenzhen, employing over 200,000 workers.

Why are markets concerned?

One word: debt.

Evergrande has been on a borrowing binge over the past two decades, fuelled by super-low interest rates and cheap credit. This has helped finance the growth of its real estate arm.

The company’s apartment blocks dominate China’s skylines, but the construction frenzy has also meant that it has racked up huge obligations to building contractors, suppliers and new off-the-plan home buyers.

But aren’t those debts secured against rock-solid property?

The potential collapse of the company has mainly come about because Evergrande’s working capital is largely tied to its inventory. Bloomberg estimates that it has around US$202 billion worth of unfinished housing projects. Around 1.5 million buyers are still waiting for Evergrande to finish their homes, with construction sites abandoned as half-finished apartment blocks.

Creditors, including unpaid suppliers and home buyers, have been offered unsold apartments as a form of ‘repayment’ for their deposits. In fact, some properties have been offered at a massive 52 per cent discount on their actual market value.

Rhodium Group director Logan Wright recently told the Financial Times that China now has enough empty property to house more than 90 million people.

Why are the Chinese government and global markets worried when it’s just one company?

China’s central bank has recently injected US$42 billion of cash into the banking system. But the Chinese government has so far offered no clues on a potential rescue plan.

The Wall Street Journal reported that Chinese central government authorities have asked local governments to prepare for the collapse of Evergrande. But Bloomberg countered with reports that Chinese regulators had asked Evergrande to avoid a near-term default.

A default of the highly indebted company would have huge repercussions for the Chinese economy. The Economist has reported that Evergrande owes money to around 170 Chinese banks and another 120 financial firms. With Chinese banks and other lenders forced to curb lending, companies may not be able to borrow at affordable rates, leading to a ‘credit crunch.’

In this instance, a slowing of credit growth would adversely impact companies who would be unable to borrow. They would then be unable to invest and hire workers, slowing down the broader economy.

What is the financial ripple effect on Australia?

Aussie investors are indirectly exposed to Evergrande through the Chinese property sector’s insatiable demand for our iron ore. The price of the steel-making ingredient, Australia’s most important export, has already halved from record highs of around US$233 a tonne in May, following China’s clampdown on the property sector and pollution.

A downdraught in Chinese property prices would further subdue construction and reduce iron ore demand. Of course, a potential Evergrande default would be catastrophic for steel demand and shares of Aussie-listed iron ore producers.