For months, global markets have been watching the struggles of China’s Evergrande Group, a teetering real estate giant weighed down by $300 billion or more in obligations that barely seemed able to make its required payments to investors. With the property giant dangling on the edge of bankruptcy, the world is being forced to contemplate a scenario it had never seriously considered: A made-in-China financial crisis. But, before we speculate on the magnitude of this crisis's impact, let's take a look at how this mega-crisis has evolved.

China’s real estate sector has been booming for more than 2 decades. As the government loosened controls over the economy in the 1990s and created an opening for capitalist principles, land ownership quickly caught up. Another factor which assisted this boom was China’s ‘Hukou System’. Under this system, when people migrated from their birthplaces to another area, they became ineligible to get government-subsidised facilities like healthcare, education etc. The solution to this was to buy a house in the area where you migrate. Thus, just as China was embarking on the gargantuan task of moving millions of people from the countryside to cities, the demand for real estate grew exponentially and the prices skyrocketed. As a result, the property sector now accounts for about 25% of China’s economy.

​

This has led to a situation where Chinese citizens have invested about three-fourth of their wealth in real estate, even by taking big debts. The craze was so profound that the government had to cap the number of properties that can be owned by a family to 3. Real estate sector has clearly transformed into the biggest investment opportunity in the country.

This is where Evergrande Group stepped in. It provided modern housing to China’s middle class at affordable rates and became China’s second largest real-estate developer. Just as property prices climbed, so did Mr. Xu Jiayin’s (Founder) wealth. Feeling flush and eager to expand, Evergrande borrowed money to dabble in new businesses. Evergrande took control of Guangzhou’s soccer club, moved into the dairy, grain and oil businesses, bottled water business and electric cars business. As the business grew, Mr. Xu was able to attract cheap and easy funding. It borrowed from around 170 Chinese banks and 121 finance companies; apart from borrowing directly from the public through Wealth Management Products (WMP). Now Evergrande epitomises the vulnerability of the world’s No. 2 economy.

 

China sensed the inflation in this over-leveraged real estate sector and began fearing a housing bust that would ricochet through China’s financial system. In August 2020 the central bank created ‘three red lines’- which defined thresholds on liability-to-asset ratio at 70%, net debt-to-equity ratio of 100%, and cash-to-short-term debt multiple of more than one time. Failure to meet these targets restricted access to additional loans. The aim was to limit the banking sector’s exposure to the property market. But it also took away the funds that developers could use to finish projects as many real estate developers had to restructure as well as halt many projects.

Evergrande, which itself had prepaid orders of 1.6 million homes, failed to meet any of the restrictions and apparently the company no longer had the means to finish their projects. Thus, Evergrande’s crisis was a deliberate choice for policy-makers who wanted to deleverage the debt-ridden real estate sector.

 

To keep the business afloat during this cash crunch, Evergrande offered its properties at 30% discount but that didn’t help. So they decided to raise over $8 billion by selling their stakes in their subsidiaries. Mr. Xu himself cut his stake in the Shenzhen-based real estate company to 67.9% from 77%. Despite its fervent efforts to raise money, S&P Global Ratings and Fitch Ratings labelled it as a defaulter over its failure to meet two coupon payments.

 

Amidst all this, the company’s stocks have plunged by about 90% and Mr. Xu has also declared that “there’s no guarantee” it will have funds to perform its financial obligations. Now, in case the company goes bankrupt, the repercussions would be profound. First and foremost effect would be on China’s economy and its financial stability. The real estate sector, construction and design firms and materials suppliers face a risk of incurring major losses, which could force them into bankruptcy. Given the wide scale of Evergrande Group’s business and the huge contribution of the real estate sector in China’s GDP, its fall might trigger an economic meltdown. Moreover, if Evergrande defaults, banks would be severely hit and might be forced to lend less, further disrupting businesses. This may also unnerve foreign investors, who could see China as a less attractive place to invest.

 

Second impact would be on global markets. The Evergrande Group owes around $19 billion in offshore bonds which are at a risk of default. China’s real estate sector is also a major consumer of imported metals and chemicals. So, troubles here will affect export markets across the world as well. Economic turmoil in the world's second largest economy will also place questions over the already stumbling global growth prospects. Contagion from the Evergrande crisis has already been showing up in the global share markets, which have seen big corrections since then. The world is worried about this crisis turning into China’s “Lehman Brothers” moment.

 

The third impact of the crisis would be social. China will be concerned by the anger and fear of millions of homeowners who have already paid up for homes that may now never materialise, as well as thousands of others who had purchased WMPs from the company and now face losses. Recently, around 100 angry investors gathered at Evergrande’s headquarters in Shenzhen, prompting the deployment of security personnel there. This evokes fears of a grave social unrest in China, which will question the Communist Party’s supremacy in China - something about which China is particularly paranoid.

 

Nevertheless, these developments mark the beginning of the end for the sprawling real estate empire started 25 years ago by Mr. Xu. The question now is whether the government can limit the fallout. The crisis is not just limited to the Evergrande Group. Already, the stocks of many other Chinese real estate firms have plunged and at least 10 of them have defaulted on onshore or offshore bonds. Property sector accounts for about one-third of China’s offshore defaults.

 

China now faces a dilemma. It needs to decide on whether the Evergrande Group is “too big to fail” and whether it requires a bailout. If it does, then a state-backed bailout would tacitly condone the reckless borrowing that’s gotten one-time high-flyers like Anbang Group and HNA Group into trouble too. This would run counter to Beijing's efforts to stop the debt-fuelled expansion of the sector. Additionally, if China bails out Evergrande Group, other cash strapped companies will expect similar government assistance, which will be too costly for China.

 

On the contrary, letting a big, interconnected company like Evergrande to collapse would reverberate across the financial system, impacts of which we have already discussed.

 

So, regulators face a delicate balancing act in allowing Evergrande to go under without generating too many waves. After sitting on the sidelines for months, the officials from state-backed institutions joined a risk committee in December to help restructure the business. China has in recent years completed restructurings via government takeovers of cash-strapped conglomerates including Anbang Group, Tomorrow Group and HNA Group. But that model may not work given the scale and complexity of Evergrande's woes. Thus, China will likely oversee a "controlled demolition" of the firm.

 

Chinese authorities have made it clear that the company should put homebuyers, suppliers, and retail investors ahead of debt holders, a move that is in line with its socialist ideology. Thus, these debt holders are at a risk of having to accept significant haircuts as the company moves towards an orderly restructuring. Beijing currently seems reluctant to bail out the developer, sending a clear signal that the Communist Party won’t tolerate massive debt build-ups that threaten financial stability. Instead, they are trying to overhaul the company’s mammoth balance sheet in an effort to pay its dues from what remains.

 

Also, to support the broader markets, China’s central bank recently released about 1.2 trillion yuan ($188 billion) of liquidity. The government also pledged to support the housing market to meet “reasonable” needs, indicating an ease in real estate curbs. China has reiterated that risks posed to the economy by Evergrande’s debt crisis can be contained, citing the developer’s “own poor management” and “reckless expansion” for the problems it faces. This might as well ease off some concerns about the crisis triggering a 2008-like crash.

 

With these developments taking place, there are certain signs of the pressure cooling off in China. The CSI 300 Index of stocks recently climbed to a six-week high, while Chinese junk dollar bonds rose 2 cents on the dollar. The yuan also strengthened to its highest level since May 2018. Shares of Evergrande Group also edged up recently after it secured a crucial approval from onshore bondholders to delay payments on one of its bonds worth $157 million, further delaying any serious crisis.

 

The future of this company obviously looks bleak but whether or not its ill-fate would spillover in the form of a global crisis depends on how carefully China engineers and controls its fall. But one thing that is certain from this saga is - market discipline will remain a central theme in China, irrespective of the risks of a moral hazard.