This week, a macro event shook the global market so much that the DOW dropped nearly 1,000 on Monday, before cuttings its losses and finishing down 614 points. The macro event wasn’t caused by an earthquake or other natural disaster, but rather a property developer in China on the brink of default.
China’s Evergrande group is a massive development company out of Shenzhen. It gained traction on the 1990’s, building homes and apartments as the country first provided access to private homeownership. Founded in 1996, Evergrande rapidly expanded its operations, now owning more than 1,300 development projects in 280 cities. However, this rapid expansion wasn’t driven by a re-investment of its earnings, but through a massive amount of leverage. And Evergrande ended up with over $300 billion in debt.
When the Chinese government created openings for new homeownership in the 1990’s, home buying caught on like wildfire. The Chinese middle class snatched up homes at a record pace. As homeownerships grew, the value of land grew with it. Evergrande swooped in and bought up large swaths of land from local governments who wanted to quickly develop new homes and apartments to keep up with demand. Evergrande facilitated this development but did so through a lot of borrowing.
For decades, regulators largely ignored the massive amount of debt Evergrande borrowed, justifying the lending due to the ever-increasing value in homes. However, as you may know, property values that rise quickly, solely due to increased buying, leads to one thing…a bubble.
Evergande became so over-leveraged that the Chinese government put a hard cap on lending it any more debt. And debt was the only way Evergrande could create liquidity. So now, not only is Evergrande unable to pay off the debt, there are nearly 1,000,000 unfinished apartments that Evergrande has no way of completing.
Evergrande’s default and ensuing real estate bubble will have an immediate impact on the real estate sector in China. The instant ramification is that hundreds of millions of Chinese homeowners could see their property value drop. When this happens, chances are they will rein in their spending. This phenomenon will be felt across the world since global consumer markets heavily rely on the spending from Chinese middle class.
Now China is caught between a rock and a hard place. If they let Evergrande default, they will be responsible for popping a major bubble and creating global market downturns. If they bail out Evergrande, they will continue to promote the bad habits that got them here in the first place.
Chances are, the Chinese are inclined to let Evergrande default but “Beijing would only be compelled to step in if there is a far-reaching contagion causing multiple major developers to fail and posing systemic risks to the economy,” S&P Global Ratings wrote in a note on Monday.
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