The Evergrande Collapse: A Potential Trigger for an Economic Crisis?

Right now, China is facing the bankruptcy of one of the biggest real estate developers in the world, with the potential for a contagion to spread through the rest of the property market. Now, over the past week or two, anyone that follows the stock market will have seen some news stories about a brewing crisis in China. Because of this, stock markets have been tumbling, and commodity prices, particularly iron ore, have really, really fallen a lot. It's basically dropped like a brick. But now we're really seeing the breaking point, and it all comes down to one company called Evergrande. Never heard of them? Well, don't be fooled. This real estate developer might just trigger one of the biggest stock market events of the decade. So, let's dive into what's going on.

This video is sponsored by Stake. Sign up today for free brokerage when trading U.S. listed stocks and use the referral link in the description for a free stock when you fund your account. China Evergrande is China’s second largest real estate developer by sales. It builds and then sells mostly apartments to the middle to upper end of the market, mostly in China’s Guangdong province. It went public in 2009, it raised 722 million on the Hong Kong stock exchange, and in 2020 generated about 507 billion yuan in revenue. That’s approximately 78.4 billion U.S. dollars.

Now, property development is definitely their main gig. However, Evergrande also owns a 50% stake in the Evergrande Football Club, with the other 50% stake owned by Alibaba. They produce a line of bottled water. They have also made forays into agribusiness, solar panels, and even baby formula. I mean, Evergrande Health, which is a subsidiary of the Evergrande Group, is also the largest shareholder in Faraday Future. So, I mean, it sounds like a company that's on the rise, right? They're diversifying, putting money into these different ventures. They're on the rise, right?

Wrong. Recently, investors have started to get a little bit worried about the amount of debt that China Evergrande has, and by a bit worried, I mean extremely worried. So worried that year to date, the stock is down 86%. Looking at their balance sheet, they have total liabilities of 1.9 trillion yuan or about 304 billion U.S. dollars. I mean, they owe money to over 128 banks and 121 non-banking financial companies. On September the 15th, China’s Ministry of Housing and Urban Rural Development told major banks Evergrande would not be able to make loan interest payments due this week. Ouch!

Interest payments on two Evergrande notes come due this Thursday, including, get this, 83.5 million of interest on an 8.25 5-year U.S. dollar bond. And for that bond, there is a 30-day period before a missed payment is considered a default. Evergrande also needs to pay a 232 million yuan, or 36 million U.S. dollar coupon on an onshore bond on the same day. In total, Evergrande has 669 million dollars worth of coupon payments coming due through the end of this year. That is, if we get that far, because yes, it is looking like the company is going to default. And at the time of recording, indications are the Chinese government is not coming to the rescue.

So, let's talk about what it means to default on your debt. So, what is a default? Well, when a company issues debt, normally it's done in the form of bonds. Bonds have a face value or principal and an interest rate known as the coupon rate. Now, the coupons are the payments that the company must make on a regular basis. This can be quarterly or every six months or every year. Then, at the end, the principal gets repaid to the investors. So, investors can buy these bonds, and then they get traded on the public markets. The more sure investors are that the company will pay back the money, the higher the price of the bond. On the other hand, if investors don't think the company will pay back the money, then the price will drop.

A company is in default if they fail to pay any of their debt repayments. Now, this generally applies to all of the company’s debts because if they fail to pay one, they're probably going to miss payments on all of them. So, what's happening in this instance? Well, in 2020, the Chinese government announced that it was going to put the brakes on the rapidly growing property sector, which many were tipping to be a bit of a bubble. They also did this because real estate is by far the most popular investment vehicle for Chinese citizens. So, they aimed to implement new rules to ensure the long-term stability of the sector.

For example, they announced that debt growth for property developers was going to be capped at 15% per year. They also announced that debt-to-equity ratios would be capped at 100%, while debt-to-assets would be set at 70%. Now, this makes it difficult for these companies to access more money if they run into problems. Usually, instead of defaulting on a debt, a company would just go out and take on another loan to pay the one that's coming due. This basically means that they can have more of their cash invested in their business, and it's also why some companies never really seem to pay off their debts, because you know, they just keep rolling them over.

However, the new rules have meant that Evergrande has had to very quickly reduce their debt-to-equity ratio, coming down from a whopping 240 in 2019 to 140 in June of this year. Now, this has been done by reducing the amount of debt on their balance sheet and has put major stress on their cash flows. They've also spent a lot of money on these other investments, such as the soccer team and electric vehicle investments, and other vanity projects that have so far soaked up cash without really providing much of a return.

Now, a few weeks ago, the Financial Times wrote an article warning that Evergrande was on the brink of default, and it turns out they were right. As I said before, interest payments on two Evergrande notes come due Thursday, and China’s Ministry of Housing and Urban Rural Development has told the major banks that Evergrande will not be able to make the loan interest repayments. So, what does this mean? Well, if China Evergrande does, in fact, go into default, there are a few options. The first and probably the worst is that it just collapses and goes into bankruptcy. Now, I'll get into this in just a moment why that would be so bad.

But the other option is that the government steps in and kind of props up the company. This probably means that some lenders will have to settle for, you know, cents on the dollar, and shareholders will likely be completely wiped out. But while this isn't ideal, it's certainly better than the other option, because, you know, the company might be able to continue operating, keep its workers, finish the homes that many Chinese citizens are waiting to move into. So, there are a lot of pluses to this kind of outcome.

But if that doesn't happen, the alternative is a total collapse of the company, which would honestly have several downstream effects, and this is what people are really worried about, and why the collapse of one company could be such a big deal. So, in the event of a collapse of the company, in order to settle their debts, Evergrande would have to start selling off some of the properties it currently owns at very, very low prices. So, essentially, what we would call a fire sale. Doing this will obviously bring prices down across the whole Chinese property market, making everybody's assets worth a lot less, and probably putting a fair bit of stress on some other developers.

So, that's the first thing. Then, the second thing that will happen is that suppliers won't get paid. Okay, the government will have first dibs on any payments coming out of Evergrande, so it's unlikely that there will be much left for suppliers after that. And this will also cause, you know, ripple effects across the whole construction industry, as contractors, as we know, contractors in the construction industry really rely on payments to be able to continue working. If a lot of contractors start going bankrupt, we could see the whole construction industry start to slow down.

Then the last key piece to watch if the company defaults is whether banks will continue lending to buyers from other property developers. Other developers are going to start coming under increasing scrutiny now that the problems with Evergrande have come to light. And if any of them seem to be on the edge, you can bet your bottom dollar that banks won't want to lend to people trying to buy their properties. That will severely limit cash flow to the other developers, potentially worsening the crisis.

To add insult to injury, Standard and Poor's have already indicated that they believe no assistance from the government is going to become available unless it becomes clear that the contagion is widespread. So, in all honesty, we could be in for a rough couple of days. I mean, people are at the moment likening this to the collapse of Lehman Brothers during the GFC. Yes, it definitely has its differences, but it also has some similarities. During the financial crisis, we saw a slow build-up, but then the collapse was very rapid. If Evergrande does go bust, that is probably what we'll likely see happen here.

If things start to collapse, it will likely happen very suddenly. Often, these types of collapses happen over the weekend because that gives the various parties time while the markets are closed in order to get things in order or at least have one last-ditch effort to try and save the company. While we obviously can't make any predictions here, I would probably say we'll have a much clearer idea of how far the contagion is reaching by Monday next week, and we'll probably have an indication of whether the Chinese government is going to step in or not.

For that reason, I don't think this is going to be the last kind of like a once-off video on Evergrande. I think I’ll probably end up making a few videos. I think I'll be making market updates on this topic across the next week because honestly, this is something that could cause a major problem. You know if it blows up, that’s the key, if. But, um, I'll try and keep you guys informed as always. But that will just about do us for this video. Guys, leave a like on the video if you did enjoy it, subscribe if you want to see more, uh, check out Profitful if you're interested, and I'll see you guys in the next video.

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