What you need to know about the Evergrande bankruptcy

China’s real estate crisis deepens, but does this signal serious trouble for the world’s second largest economy?

A crisis has been brewing in China’s property market since a significant change in policy by Beijing in 2020. In the last week, Evergrande finally succumbed to its staggering debt, and other developers are on shaky ground. We explain what led up to this, and what it may mean for China given the property sector accounts for a quarter of that economy.

What happened?

On 18 August 2023, the China Evergrande Group filed for bankruptcy in the US. Leveraging Chapter 15, Evergrande took the action to help protect their US assets while they restructured A$468 billion in debt.

Evergrande is the second largest Chinese property developer by sales, and responsible for significant residential developments. Once the largest player, this bankruptcy claim comes after Evergrande stumbled in 2021 and started missing debt repayments.

There’s no doubt the sector is struggling. Country Garden, formerly the largest property developer in China and now sitting at 6^th, has also recently defaulted. These are just two examples of the many developers that aren’t completing projects.

Further to this is the reverberation through the trust sector, China’s shadow banking system, that has substantial exposure to property developers. One trust bank, Zhogzhui, failed to meet payments on investment funds last week.

What led to this?

In 2020, the Chinese government implemented the ‘three red lines’ policy to inhibit out-of-control borrowing by property developers. Essentially, this policy restricts the amount of new borrowing by developers each year.

The policy was intended to dampen housing prices and, as Xi Jinping stated, create housing for living rather than investing.

However, real estate companies started struggling to find financing to complete developments and to keep up with debt repayments. As a reasonable proportion of residential property is sold off a plan, this created a cycle where some buyers stopped mortgage payments as work on developments stalled.

What does this mean for China’s economy?

The real estate crisis adds to the economic woes in China. Post the tough measures instigated during the covid pandemic, China’s economy has failed to bounce back. In July, the country slipped into deflation as consumer prices declined.

However, the challenges in the real estate sector and in the trust sector are not new. The issues at Evergrande and Country Garden have been well known for some time.

CFS Chief Investment Officer, Jonathan Armitage, said, “These two failures should not present a systemic risk and the PBOC [People’s Bank of China] has been running various policies to separate weaker lending organisations from the large, systemically important banks.”

Does this mean the real estate crisis doesn’t pose an economic threat? Jonathan qualified, “The wider question will be on Chinese consumer sentiment which has taken a hit due to the issues in the property sector.”

Will the government step in?

In a move to support the property sector, at the PBOC’s monthly meeting on 21 August, the 1-year lending rate was cut by 10bps. However, it came as a surprise to some economists that the 5-year rate remained unchanged.

In the view of Al Clark, CFS Head of Investments, this wasn’t completely unexpected. “This is consistent with the ‘drip irrigation’ approach the government has steadfastly stuck to, rather than making any mass changes to monetary policy.”

“We do expect further stimulus measures in the coming months but more focused and concentrated than a ‘big bang’ given the shift to more targeted responses,” Al said.

In a sign of this, last week regulators issued a series of measures to make it easier for companies to buy back shares and cut transaction fees for investment companies in order to improve retail investor confidence.

How have markets reacted?

Markets have taken the recent events in China in their stride, and we have so far not seen increased volatility. This in part is because these were known issues, and the serious hit having already come in 2021 when the fear of contagion drove markets down.

Will the Australian economy be impacted by this crisis?

Last week, the Australian share market had its worst week in almost a year which was somewhat attributed to concerns about the impact of China’s economy on our own. While not directly related to the property crisis, speculation about the impact on commodity prices, particularly iron ore, contributed to this.

Overall, some of the economic friction with China has eased more recently and restrictions on wine and wheat have lessened somewhat. There does appear to be a more pragmatic approach from the current government about economic issues which have been independent of the property market challenges. 

What’s next?

Signs suggest that China’s economy isn’t just going through a rough patch. An aging population, rising unemployment, slow growth, and deflationary conditions, are dragging down market sentiment. We’ll be watching to see if Beijing will continue with it’s ‘drip irrigation’ approach, or implement more widespread, systemic changes that may be required to turn the economy around.