Unless you’ve been living under a rock for the past week you’ve probably heard of Evergrande and the mountain of debt it is currently suffering under.
So big is the mess that people are calling this the next Lehman Brother’s moment. A default so large that its effects will be felt all around the world.
For most people, however, understanding the crisis might prove to be a little difficult considering the financial jargon many journalists use when explaining.
Here, I like to keep it simple to ensure that everybody can understand.
So here is what you need to know about the Evergrande crisis.
What is Evergrande?
Evergrande is one of China’s largest real estate developers, the second largest one to be exact. Established in 1966, the company specializes in developing real estate for its investors and then sell/rent for a profit. It is one of the largest businesses in the world in terms of revenue hence it’s listing as part of the Global 500 (list of the biggest 500 companies in the world).
Evergrande is listed in Hong Kong and has a workforce of 200,000 people with a further 3.8 million jobs sustained by the company’s activities.
As a property developer, the company boasts “more than 1300 projects in more than 280 cities” across China.
The company has however invested in a variety of industries including electric vehicles, theme parks, food and beverages and even sports.
The company’s investment in sports has been one of its most outstanding ventures. It currently owns soccer team Guangzhou Evergrande who with the help of its parent company has built what some are calling the world’s biggest soccer school at a whopping $185 million.
Currently, the company is working on building on what will be the world’s biggest soccer stadium at a cost of $1.7 billion. The stadium, if completed, will be shaped like a giant lotus flower with a carrying capacity of a massive 100,000 spectators.
How did Evergrande get into trouble?
Evergrande’s problem can be summarized into one word: debt; specifically, $300 billion worth of liabilities.
How were they able to accumulate such massive amounts of debt? Well, it’s just part of its operating model. You see, large property developers like Evergrande build huge properties on the promise that the housing prices will keep rising.
Now, this is not a bad thing, property companies do this all the time. They take on huge sums in terms of loans and investments and use them to build properties which they then sell at a profit. For the most part, this strategy works. China’s demand for housing has been rising consistently for the better part of the last decade. Evergrande has been one of the few companies key in meeting this ever-rising demand for housing, of course, generating lots of profits in return.
Their model was however shaken and, I would argue, completely destroyed when the Chinese government decided to clump down on businesses deemed to have unsustainable debt levels. In a bid to protect its citizens from future economic risks, authorities introduced three tests that were used to determine a company’s debt tolerance. No surprise then that Evergrande failed all three of these tests; a $300 billion debt is difficult to explain no matter how big you are.
The result was that Evergrande couldn’t borrow any more money, the key source of their cash inflows.
This meant an almost complete halt on their operations while at the same time facing the huge mountain of debt they have no clear means of repaying back.
Moreover, a quick look at the company’s accounts will reveal that the company, despite an ever-growing working capital, is not as healthy as it looks. While its assets are significantly more than liabilities, much of its properties are priced at face value. This is despite complaints that many of them are still underdeveloped or have deteriorated.
And, while Evergrande could simply sell off a bunch of its sellable assets to generate some cash flow, the current state of the Chinese property market would mean that they would risk running huge losses.
In a note, chief Asia economist at Capital Economics explains:
“The root of Evergrande’s troubles — and those of other highly-leveraged developers — is that residential property demand in China is entering an era of sustained decline. Evergrande’s ongoing collapse has focused attention on the impact a wave of property developer defaults would have on China’s growth.”
Will this crisis affect you?
Unfortunately, the answer to this is, probably. As I pointed out earlier Evergrande’s crisis has been likened to Lehman’s collapse. A debt so large that it eventually led to the 2008 global economic crisis.
You are probably wondering how the fall of a single company could have such disastrous effects.
Well, this is due to the high level of interconnectedness of the global financial system. A single fault in the system may result in its total collapse.
In Evergrande’s situation, for instance, the bankruptcy of the second-largest property developer in China first means that direct stakeholders like investors, suppliers, customers and employees will lose a lot of money and consequently fail to meet their obligations to their stakeholders.
Moreover, a lot of people will be out of a job, investors will lose money and suppliers will lose key sources of revenue. Banks will be warier of lending to businesses while investors will be more cautious or even pull out of such risky options causing an overall drop in share prices across the board; more people lose money. Such is the connectedness of our global financial system. If one large player falls, the whole system may go down with them.
This does not mean that you may be losing your home very soon but it may cause a slight spike in bank interest rates and yes, some companies may lay off a few workers to make due.
This is however the worst-case scenario and many analysts believe that the crisis will not reach 2008 levels. Authorities will likely cushion their nations from such disastrous outcomes. For instance, the Chinese government while stating that they won’t bail out Evergrande, have reportedly already injected $18.6 billion into the banking system to increase liquidity. This will help cushion banks from Evergrande’s fallout and thus protects their customers’ deposits.
Can Evergrande be Saved?
To save such a mess would require a huge bailout, something that the government has already stated it won’t do. Beijing is only interested in protecting thousands of customers who had bought unfinished apartments as well as suppliers, construction workers and small investors.
Furthermore, a cash injection from Evergrande’s billionaire founder was rejected by the Guangdong province.
And even if the company did manage to secure a few cash injections, it may be too late to save the company. The Chinese media referred to Evergrande as a “huge black hole” which implies that no amount of money can save it.
All signs point to a large default by Evergrande. The impacts from this would be interesting, to say the least.