The liquidity problems of the Chinese real estate developer Evergrande are heralding the end of the real estate boom in China.
The economic boom of China has gone hand in hand with an unprecedented boom in the real estate industry over the past decades.
However, this boom has its drawbacks and has led to an oversupply in recent years: according to a report by the Financial Times, the current vacancy rate in China would provide housing for more than 90 million people. A small number for China, but remarkable from a European perspective. After all, the vacant apartments would be enough to accommodate the entire population of one of five G7 states (France, Germany, Italy, the UK, or Canada).
“Real estate prices in China are stable.”
Wilhelm Spitaler, Portfolio Manager of Erste AM
The collapse of Evergrande: a self-inflicted malaise
The Chinese government reacted to the real estate boom and the resulting risks such as oversupply and speculation by imposing regulatory measures: Beijing has drawn – as the Financial report goes on to explain – three “red lines” in order to reduce the leverage: the ratio of debt to assets has to be below 70%, the ratio of net debt to equity has to be below 100%, and the ratio of cash to short-term liabilities has to be at least 100%. Evergrande violated all three thresholds, which led to the company being prohibited from taking on any further debt and thus caused financial difficulties and the current crisis. Said crisis is now increasingly turning into a political one.
The real estate market is an important part of the Chinese success story and thus also important for the future development of the country, which has proclaimed the motto of “common prosperity”. Rising real estate prices and prosperity are closely linked to the prospering economy; the government in Beijing has to ensure the sustainability of this development. Prosperity can also be achieved by way of innovation or the development of green technologies; here, China is currently in transition; this transition seems compromised by the problems of a large real estate company.
A bail-out of the company could lead market participants to a point where they, too, would want to claim help from the state. This is something the government in Beijing cannot and surely will not support.
However, as the volatile market has shown in recent days, a bankruptcy could also have negative effects on the economic development of China as a whole and put the political goal of common prosperity at risk.
Next days show if the problem is solved
The coming days and weeks will therefore probably show how the problem can be resolved; the most likely scenario is some sort of orderly liquidation that will cause the investors losses but that will prevent any spill-overs into other economic areas.
Evergrande is the first victim of the Chinese governmental regulatory measures – and unfortunately one of the biggest companies in the Chinese real estate sector. This is why the impact can even be felt on the US and the European stock exchanges.
To be fair, the rating of the company was never particularly good; it was never considered investment grade; indeed, the international rating agencies had rated it highly speculative for years. The economic downturn caused by the corona pandemic has now led to financial difficulties. Any economic ripple could really have set off a situation like this, so we should not be surprised.
We are somewhat surprised though about the limited effect the Evergrande story has had on the real estate prices in selected Chinese cities, as shown in the graph above. We shall take this as positive signal that any negative effects from a possible Evergrande bankruptcy will remain within reasonable limits.
Prognoses are no reliable indicator for future performance.