China's 'Lehman moment'

Evergrande crisis can have global ramifications

Financial stress in China’s largest real estate developer, Evergrande, has led to turmoil across global markets. Commentators are referring to this as “China’s Lehman moment”, in comparison to the 2008 bankruptcy of Lehman Brothers, which was a trigger for the global financial crisis. Around 29 per cent of China’s gross domestic product is related to real estate. Evergrande has a total debt exposure (including trade payables) of over $300 billion, which includes $19 billion in offshore US dollar-denominated bonds. The real estate giant has issued warnings that it can default on $80 million worth of interest payments, due this Wednesday. Last week, trading was halted in Evergrande’s yuan debt, after rating downgrades. Fears of this default have led to a crash across Chinese debt assets, and triggered big sell-offs in stock markets across Hong Kong (where Evergrande is listed), other Asian markets, including India, as well as in Europe. It has also triggered a panic sell-off in industrial metals and fuels. The prices of real estate stocks in Hong Kong have dropped to 2016 levels, while real estate bonds yields have spiked to 14.5 per cent.
 

Evergrande’s balance sheet shows 128 banks and 120 other institutions with direct exposures. This includes global investors like BlackRock, Amundi, UBS Asset Management, Ashmore Group, HSBC Holdings, Fidelity, PIMCO, and Goldman Sachs Asset Management. The company has been unable to complete many of its 1,300 ongoing projects. Apart from financial debt, Evergrande is said to have over 667 billion Chinese yuan (about $103 billion) in outstanding trade payables. It will have another 240 billion yuan ($37.16 billion) of trade payables to settle in the next 12 months, if it remains a going concern. The cash crunch has led to over $1 trillion worth of Evergrande projects being unfinished. If there is a contagion, or a default leading to bankruptcy, it would affect economic activities in China, which in turn, may have cascading negative consequences for the world.

The financial stress has been caused by tighter controls imposed by the People’s Bank of China, and a slowdown in housing demand. Some estimates indicate unsold inventories of 60-65 million units across the People’s Republic of China. Mortgage lenders could therefore be in trouble as well. China’s real estate has debts of over $4.5 trillion, of which $209 billion is parked in offshore bonds. In 2020, the PBoC capped real estate developers’ access to credit setting “Three Red Lines” to reduce speculation. The red lines are at dangerous thresholds on ratios like liabilities to assets, net debt to equity, and cash to short-term debt. In June 2021, Evergrande breached all three lines and received rating downgrades from Fitch and Moody’s. Since then, it has reportedly been paying up to 36 per cent interest on short-term unsecured borrowings.

Although Evergrande can easily be classified as “too big to fail”, there are no assurances yet of a bailout from the PBoC. If it does default, every major central bank will probably open liquidity taps to ensure global markets don’t freeze in contagion. The US Federal Reserve will very likely take this into consideration at this week’s meeting. A fall in Chinese activities will also hurt commodity metal and fuel players, given China’s dominance in manufacturing. If the yuan falls, exporters everywhere else will also be under intense pressure. The PBoC is obviously cognisant of the economic consequences, given its prior actions. It is now up to the Chinese political leadership to weigh the geopolitical ramifications of letting Evergrande stand, or fall.