Evergrande, China’s largest and most indebted property developer, has recently been in the news for missing interest payment deadlines, putting the firm at risk of bankruptcy. Investors are concerned with the possibility that such a collapse could have a contagion effect that ripples through the rest of the Chinese economy.    

Just a few years ago, Evergrande was the world’s most valuable real estate stock. However, since its peak in 2017, its stock has dropped substantially from its high, down nearly 80% year-to-date.

While fears of Evergrande’s collapse sparking an economic contagion across China (and possibly beyond its borders) are increasingly fading, this situation remains important for investors across the globe due to China’s economic influence. Beyond the rise and fall of a single company, Evergrande’s collapse and the Chinese government’s approach to handling the situation sheds valuable light on the sustainability of Chinese economic growth and the viability of the methods it has used to propel itself to becoming one of the world’s largest and most productive economies.

Real Estate Powered China’s Growth

The real estate sector, in general, takes on high levels of debt. However, the degree to which Evergrande’s balance sheet was levered sparked fears that the company would be increasingly unable to make whole on its financial obligations. As concerns about China’s real estate market grew, the sector continued to power the country’s massive economic growth, accounting for an estimated 29% of China’s entire gross domestic product (GDP). This compares to a contribution of closer to 22% for the U.S.

As real estate prices continued to rise, the bubble was fueled by increasing debt and leverage. This led to speculators purchasing homes months or even years before the houses were built. Additionally, the prospects of continued appreciation of real estate (coupled with strict limitations on overseas investing) led to the construction of China’s infamous ‘ghost cities’ that litter the countryside with cities full of buildings that sit empty. It is estimated that 20% of the total housing stock in China is unoccupied.

Last year, the Chinese government took steps to reign in the real estate sector.  They slowed down property sales by setting mortgage interest rates higher and reducing sources of liquidity for real estate firms by enacting a policy known as the Three Red Lines. This policy aimed to reduce the amount of interest-bearing debt and reckless borrowing in the property market and ultimately produced what was referred to as a ‘controlled demolition’ of the real estate bubble. 

 Evergrande’s Collapse

It is largely because of this deleveraging campaign by the Chinese government that Evergrande has come under pressure. The restrictions that these new measures put in place have caused the company’s large debt levels to come under scrutiny, resulting in several downgrades and an increased risk of default. However, the negative impact that these policies have had is not limited only to Evergrande, as many other Chinese property developers are also experiencing increased scrutiny. The focus on Evergrande is more a factor of its large size rather than its exceptional financing methods.

Because Evergrande is the most significant player in the Chinese real estate market, there were concerns that if the company failed, a contagion of defaults would rip across the economy. However, because the largess in the sector was well known and the Chinese government had taken preemptive steps to slow down its unsustainable growth, the issue appears to be contained.

Despite its large size, Evergrande still represents a low single-digit percentage of the massive real estate market. While the Chinese government has been reluctant to step in and bail Evergrande out, a government-aided unwinding of the troubled company will likely happen and would be viewed positively by investors.  

Conclusion

More important than the fate of Evergrande specifically is the potential impact that slower growth in China will have on the region and the rest of the world economy. With the real estate bubble that has been the driving force behind China’s explosive growth deflating, future growth must come from elsewhere.

In July, President Xi Jinping said that he wants China to focus on “pursuing genuine, rather than inflated GDP growth, and achieving high-quality, efficient, and sustainable development” for its economy. An overleveraged real estate market does not align with this new vision. The ability for China to successfully pivot towards genuine economic growth remains to be seen, and the failure to do so will have consequences that could impact investors across the globe.

Jonathan Koop, CFA, is a Senior Portfolio Manager with Bedel Financial Consulting Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.bedelfinancial.com or email Jonathan at jkoop@bedelfinancial.com