INTRO: Remember Evergrande?
In late September and early October of last year, they were the star of financial news.
Everyone was worried about what would happen if this massive Chinese institution defaulted
on their debt and the ripple effects that it would have on the world.
We saw headlines like “Fed warns China's property problems could hurt global markets
and the US economy” and “Wall Street marks biggest drop since May as Evergrande crisis
intensifies”.
Yet, as the fed started raising interest rates and the stock market started to sell off for
other reasons, it seems that most people have completely forgotten about this once monumental
threat.
This isn’t to say that the Evergrande situation can be completely ignored though as the crisis
has only gotten worse.
In fact, at the end of last year, Evergrade defaulted on $1.2 billion worth of foreign
bonds.
And as you would guess, their stock price has only fallen further and further into abyss
standing at just 17 cents today.
So, whatever happened to the Evergrande crisis, and does Evergrande even matter on a world
scale?
THE BIRTH OF EVERGRANDE: Before we get into the potential consequences
of the Evergrande crisis, let’s first take a look at how this crisis even formed in the
first place.
This wasn’t something that just took place over a matter of years.
Rather, this issue has actually been brewing for decades going all the way back to the
1970s.
You see, in 1978, the Chinese government adopted a new economic policy that many scholars call
“China’s Open Door Policy”.
Before this ideology was adopted, China was completely closed off to the world economy.
They practiced an ideology called “zhong xue wei ti, xi xue wei yong” which translates
to "Chinese Learning as Substance, Western Learning for Application" As the name suggests,
China was intent on maintaining their traditional culture as well as their communist political
and economic system.
However, they were willing to import technology from the west and implement it into their
society.
While this strategy worked decently for much of the 1900s, it came with a slew of shortfalls.
First of all, China was barely involved in foreign trade, and secondly, no one wanted
to invest in China which made it increasingly difficult to keep up with the west.
Not to mention, China’s economic and political landscape had been devasted by the Cultural
Revolution which took place between 1966 and 1976.
So, in 1978, China finally gave in and adopted the “Open Door Policy”.
Things didn’t just change overnight though.
China spent years deciding which sectors they needed to control and which sectors they could
loosen up.
China was by no means willing to give up land ownership, but they were willing to privatize
how the land was used and this brings us to the Amendment Act of 1988.
This amendment made it possible for companies and individuals to use land to their liking
by obtaining land use rights.
This opened the door to a wide number of entrepreneurs who were looking to build real estate and
property development companies.
As you would guess, Evergrande’s founder, Xu Jiayin, fell under this category.
Xu was actually a bit late to this trend as he didn’t start Evergrande till 1996 which
is 8 years after the amendment was adopted.
Nonetheless, Evergrande would leverage this new opportunity to the max and the company
would grow exponentially over the next two decades.
Evergrande’s growth was only further accelerated by new China joining the World Trade Organization
in 2001.
This made Chinese investments more appealing than ever before which allowed Evergrande
to grow an international base of investors and stake holders.
Ironically, Evergrande actually went public during the height of the great financial recession
in October of 2009.
But despite this, they were still able to raise $722 million which just goes to show
how much interest their was in Chinese real estate amongst international investors.
All of these factors would allow Evergrade to become one of the largest property developers
in China and one of the biggest companies in world.
In fact, the company was and still is part of the Global 500 coming in at rank 122.
This monumental growth didn’t come for free though.
Evergrande was constantly taking on more and more risk which would eventually come to back
haunt them.
GHOST CITIES: One of the biggest risks of the Chinese real
estate market over the past 2 decades has been the ever growing real estate bubble.
One of the most famous examples of this is the dozens of ghost cities located across
China.
If you’re not familiar with China’s ghost cities, these are essentially massive developments
that never became inhabited.
Oftentimes, you see dozens of skyscrapers and buildings that are completely empty and
sometimes not even finished.
Now, you might be wondering, how in the world do these ghost cities even form in the first
place?
Well, if we take a look at Chinese real estate law, we’ll quickly begin to understand how
exactly this happened.
China separates real estate developments into a few different categories starting with economically
affordable housing.
China requires that such projects are occupied by the owner and these projects cannot be
bought or sold as an investment.
On top of this, real estate companies cannot sell these properties for more than 5% over
the construction cost.
So, these projects aren’t particularly lucrative or appealing.
One category that is super appealing, however, is commodity housing which can be bought and
sold as an investment in most cases.
And in China, there’s extraordinary demand for real estate.
Real estate is often thought of the best way to grow generational wealth, so even many
middle class families opt to buy 2nd and 3rd properties as soon as they can afford it.
Also, China has yet to experience a 2008 style housing market collapse, so as far as the
everyday Chinese person knows, real estate prices only go up.
And, honestly, this is not a bad bet.
Even if there is a crash, it’s just a matter of time until real estate recovers because
people will always need land.
But, here’s the problem, you can’t own land in China.
So, if you want a piece of real estate in an area that you think will develop in 20
to 30 years, you have to build something on it right now.
And when millions of Chinese people are thinking the same thing, it doesn’t take long to
garner enough demand to build an entire ghost city.
So, while these cities are indeed mostly if not completely empty, they’re also completely
sold out.
This has provided Chinese real estate developers with unprecedented demand.
But when all of your demand comes from investors and not people who are looking for a primary
residence, it just takes one market downturn to obliterate your demand.
TURNING A BLIND EYE: But, wait a minute, there’s no way the Chinese
government didn’t see what was happening right?
How did they not think to stop this unsustainable practice?
Well, the answer is two fold.
First of all, local governments are super incentivized to sell land rights to these
development companies.
You see, municipal governments only get keep about 40% of the country’s tax revenue.
The rest must be passed on to the CCP.
However, local governments have to pay for 80% of their expenses.
So, local governments have to do something to overcome this funding disparity, and the
easiest answer for them has been selling land rights.
In 2015, for instance, land transferring fees accounted for 40-60% of local government revenue.
This is not that surprising when you consider that land sales brought in $438 billion for
local governments in 2012.
I don’t think I need to explain why local governments were a fan of ghost cities, but
what about the CCP.
Surely, they could see how this was a massive bubble waiting to blow up right?
Well, they did, and they would eventually take action, but now before letting the situation
get too far out of hand.
You see, the CCP was also massively incentivized to turn a blind eye to these ghost cities.
The CCP wasn’t directly pulling in cash from land sales like local governments, but
they were able to pump up the Chinese GDP.
The Chinese real estate industry accounts for 29% of the entire country’s GDP.
So, letting these ghost cities pop up was extremely beneficial in terms of catching
up and beating the US in terms of GDP.
At first, this wasn’t a big issue as real estate developers were pretty responsible
financially.
But, it didn’t take long for greed to kick for developers like Evergrande.
They started taking out substantially more debt, and their debt to equity ratio fell
off a cliff.
For example, in 2014, Evergrande had ¥112 billion in equity and ¥206 billion in assets.
This gave them an extremely healthy debt to equity ratio of 0.839 meaning that they had
more equity than debt.
By 2020, their equity had grown to ¥350 billion which sounds good until you realize that their
assets had grown to ¥2.3 trillion.
This results in a super dangerous debt to equity ratio of 5.57.
If Evergrande was an average American, they would’ve had to take out PMI or private
mortgage insurance because they didn’t even have 20% equity.
This issue wasn’t just limited to Evergrande either.
Many Chinese real estate companies were in similar positions which made it abundantly
clear to the CCP that they had to take action.
TOO LITTLE TOO LATE: In August of 2020, Chinese regulators met
with the country’s largest real estate companies including Evergrande and they introduced three
restrictions called the three red lines.
These restrictions put caps on three debt ratios which were debt to cash, debt to equity,
and debt to assets.
As you would guess, Evergrande didn’t exactly fall within these restrictions, so they would
start selling off properties and raising cash.
For example, in September of 2020, they discounted properties by 30% to increase sales.
Similarly, in October, they raised $555 million by completing a share offering.
They also cancelled certain projects, but none of this was enough to improve their financial
situation substantially.
Nonetheless, Evergrande was able to stay afloat thanks to sufficient cashflow, but it didn’t
take long for this to go downhill as well.
In late 2020, Jack Ma and the CCP would get into a bit of a conundrum which prompted the
CCP to crackdown on Chinese tech companies.
While most of the CCPs actions were directly targetted towards tech companies, as tech
stocks crumbled, so did investor confidence.
And as investors started pulling back on real estate investments, Evergrande’s net profit
started to decline as well.
In August of 2021, Evergrande reported a 29% year over year decline in net profit.
And given Evergrande’s already fragile position, this was enough for default fears to go rampant.
Evergrande continued to insist that while they were facing issues, there was nothing
to worry about.
You could say that these were their famous last words as Evergrande would miss their
first set of coupon payments just a few weeks later.
Shortly after, Evergrande would begin missing coupon payments on a regular basis until they
eventually defaulted on $1.2 billion worth of debt.
CCP TO THE RESCUE: The CCP has never publicly acknowledged that
they’re bailing out Evergrande, but that’s basically what they’ve been doing.
They’re not exactly saving the company itself, but they’re trying their best to ensure
that the collapse of Evergrande does not lead further consequences.
And the main way their accomplishing this is by nationalizing the company.
For example, local governments have been seizing rights granted to Evergrande.
Similarly, China’s central bank freed up $188 billion to help alleviate any liquidity
problems caused by Evergrande’s default.
Evergrande has also been selling parts of their own business to raise cash and pay off
debt.
So, at this point, it does look like China has Evergrande under control and that they’ll
be able to contain the crisis, but only time will tell.
Do you think the Evergrande crisis is behind us or is it just a preview as to what’s
to come?
Comment that down below.
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