Is There a Risk of Contagion in China from Evergrande?
There has been quite a lot of talk in the media over the Evergrande debt fiasco in China.
On Thursday, Moody’s downgraded their company’s credit rating to CA, saying they did not have enough funds to cover their debt. And early this morning, Chinese officials authorized the company to work on restructuring its debt.
While the story is interesting in many aspects, so far, it has a narrow scope.
The question is whether this is just a matter of poor financial management in one company, bad luck, or the tip of the iceberg for other credit problems in China.
Could this be a problem for other Chinese developers too? And what would that mean for the Chinese financial system?
What’s the real problem?
Evergrande is China’s second-largest housing developer, and they primarily construct apartment buildings throughout the nation’s biggest cities.
These projects tend to be capital-intensive and are built at scale. Generally in Europe, apartment buildings are built one at a time, whereas many Chinese developers, including Evergrande, built entire city blocks all at once.
On the one hand, this allows for faster building per unit and has a lower cost. On the other hand, the company has to incur large amounts of debt in anticipation of selling the properties.
Selling homes in China has not been a problem for the last several decades. This allowed developers to take on increased amounts of debt, with gearing ratios well above the generally recommended 30%.
The big problem
Debt isn’t an issue if you can pay it back. However, in the aftermath of covid, many Chinese families were reluctant to buy homes, and some were simply not able to because of lockdowns.
A couple of months of not selling would significantly undermine companies’ cash holdings, as they expected regular cash flow from sales to cover their debt.
In turn, that would make financial institutions less willing to loan them cash for the developments needed to pay back their debt. Overall, this can produce a negative feedback loop, leading the company into increasingly tight financial conditions.
Evergrande reported a 26% drop in contracted sales as a result of covid restrictions. And despite increased profits, they have been struggling to make timely payments.
Other firms, however, have reported an increase in contracted sales. This is despite the latest government authorities’ moves to clamp down on what they see as an overheated property market.
So, where are things going?
The Evergrande debacle comes at a time when many investors are cautious about economic signs from China.
Recently the PBOC lowered its reserve requirements in an easing move to boost the economy. President Xi’s remarks a couple of weeks ago about the need for more “solidarity” from wealthy citizens gave the impression that the government is facing lower tax revenue. In fact, this is a sign of economic underperformance.
Housing is a “safe haven” for Chinese citizens looking to save money. If Chinese people are experiencing less disposable income – whether this is because of a lack of employment or rising inflation – there could be some pressure on the housing market.
Nonetheless, as long as the general trend remains for increasing sales, Evergrande might simply be a cautionary tale against overleveraging.