China Evergrande Default: Great Recession on Steroids?

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The Fitch ratings agency has officially classified the real estate firm Evergrande as ‘restricted default' now that the grace period has ended. What Now?

People’s Bank of China, the Central bank of China has provided grim forecasts for the year 2022

Now that the waiting period is over, China Evergrande has officially defaulted, with billions of dollars or foreign and domestic bonds unpaid. There is no mistaking this, a multi-billion dollar conglomerate is now bankrupt. Billions of dollars of investor money are wiped out. Banks that have lent money to these firms have indirect exposure resulting in distressed balance sheets and credit crunches. Middle-class individuals who invested their life savings in real estate now stand to lose everything. The fallout from this could set the global economy back by trillions of dollars resulting in massive job losses, financial distress, largescale business bankruptcies. So what happened here? How did we get here? And are we headed for a massive global financial crash?

Growth Story

The Shanghai Bay Area has seen massive investments and changes to its skyline in the past decade

China’s growth has been nothing short of phenomenal over the past three decades. Their growth rates have consistently been in the double digits or in the high single digits. The past three decades saw the south-east Asian nation become the manufacturing capital of the world, exporting almost everything there is to export, protecting and growing their own industries, unabashedly copying and stealing patents and designs and aggressively chasing growth to become the second largest economy in the world. Their fast growth was enabled by their large and young population (1.3 billion) and the relative ease of growing the country by providing for their massive needs. If you have a billion people simple projects like building roads, railways bridges, laying electric lines and pipelines, providing internet connectivity, building apartments and buildings to house the said population and maintaining all of this will enable any country to hit double digit growth rates. Not to mention, they managed to attract massive amounts of foreign capital and investments due to their young cheap labor and disregard for labor laws and rights that saw many companies outsource their manufacturing post their entry into the World Trade Organization. China was a beast unleashed, on its way to reclaim its position as the world's economic hegemon.

Origins of the Bubble

China is a country that prioritizes growth over everything else. Growth at any and all costs is the most important thing for the CCP and the broader Chinese government. They achieve this through massive infrastructure projects and investments. Thus, one of the primary sources of revenue for the government at the state and local level is the lease of land to developers and institutions. Land in China is owned by the government and can only be leased by the people, organizations, developers and institutions for a certain period of time — 60 to 100 years is the average time range of one of these contracts. While this may seem reasonable on paper, these land sales involve ridiculous sums of money, mostly in the hundreds of millions of dollars and or renminbi. There is also widespread corruption with the party officials providing key pieces of land at subpar value to their friends and relatives and making up the revenue differences by overcharging for less lucrative pieces of land. Just like everything else, the start of the bubble involved bad unchecked government policies and blatant corruption. But this situation began to get exacerbated when other factors came into play much later on.

China Evergrande group is currently $ 300 billion dollars in debt and has missed two deadlines and the grace period for repayment of foreign debt

In China, real estate is the major form of investment. Everybody and their mothers are invested in real estate. According to official and unofficial estimates close to 70% of China’s huge and growing middle class savings are invested in real estate. There is a reason for this. China’s stock and bond markets are notoriously volatile due to the opacity of many of its institutions and big companies. In China, shadow banking is a very real thing with many companies maintaining public and private balance sheets both legally and illegally. This makes it difficult or next to impossible for people to get a read on a company and its financials. There have been multiple stock market corrections and swings in China over the past twenty years, which have seen many big and well-known companies go under and middle class investors loose their savings. There is zero trust in the financial markets and in companies. The only safe and reliable investment that the Chinese people had was real estate.

The ‘Bubble’

Due to the lack of trust in financial institutions and the domestic stock markets, Chinese retail investors stopped and or reduced their investments in these instruments and turned to real estate. Just like anything else, when there is a massive and concentrated flow of cash into one particular sector that happens unchecked for many years, bubbles start to develop. An average well off Chinese citizen holds at least two or three houses. Housing has also become a financial milestone that Chinese youths have to achieve in order to get attract suitable mates in China’s female deficient dating pools. But just like the situation before the 2008 crash, there are more homes in supply than there is demand. According to many estimates, there are close to 65 million vacant homes in China. Entire city blocks and cities sitting vacant and unoccupied. Despite this, average home and rent prices are so high the it is unaffordable for China’s youth.

The ‘lie flat’ movement is gaining steam among China’s youth as a social protest against stagnating upward social mobility

Perhaps it is in a bid to curb this, that President Xi’s government instituted the three red line policy for credit in 2021 that sets limits for overleveraged financial borrowing. Most of China’s developers fund their projects not through profits or leveraged borrowing, but through uncontrolled levels of borrowing which has resulted in massive levels of debt (in the trillions of dollars). They were paying off many of their debts by taking on more debt. This has reached the point where they are now no longer able to pay off the interest of the debt taken nor complete any of the projects that are in progress now. Investors and citizens are also losing faith in the real estate markets as evidenced by slumping home sales and industry growth in the last two quarters.

Why it Should Matter to You?

A crash in China can cause resultant crashes and credit crunches around the world. Being the world’s manufacturing hub, and also a place of investment for many, a crash in china can throw the entire global economy into another big recession. At the height of the 2008 crash, the US housing market stood at $30 trillion. China’s housing market sits at $62 trillion. A third of their annual GDP comes from real estate. Even single digit corrections can result in trillions of investor dollars lost. At the time of writing this blog, Evergrande shares have stopped trading as their value has plummeted by 99%. There are a combined $197 billion dollars of real estate developer repayments due in January of 2022, which in all likeliness, won’t be met. There will be a subsequent knock on effects as well as many companies and banks with exposure to these companies will lose their investments, trillions of dollars of middle class savings wiped out, millions of jobs lost and many credit dependent companies going under. The effects of this crash will be felt by every country and people everywhere. As someone rightly said — When China sneezes, the World catches a cold.

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