How Can Evergrande’s Contagion Occur? 1
What a way to start the week. The impending, and at this point seemingly ineluctable default of China’s largest real estate developer, Evergrande, saw global markets awash in a sea of red on Monday. What are the broader implications of this?
In order to answer this question, we need to first grasp that while the problem is, at this point, mainly one for the Chinese economy, it has the potential to reverberate around the world.
Let’s begin with the Chinese real estate market, which has famously been booming for more than a decade now. While the word “bubble” has been thrown around for a good part of the last ten years, the general belief was that the Chinese government would somehow be able to contain, or print their way out of the problem.
Unfortunately, they have chosen not to do so as Evergrande teeters on the edge, although it should be noted that if the market response is vehement enough, i.e. Chinese lending markets completely freeze, it is quite possible that officials will change their stance.
However, in the absence of any move by the Chinese government hinting at such a change, Chinese real estate developers will find it challenging to tap the bond markets for capital, as lenders wait to see just how much financial contagion Evergrande’s default will create.
Even though Evergrande’s high level of indebtedness has been cause for concern for some time, the default of the country’s largest developer still raises questions about the health of China’s housing market. Is this simply a story of a developer overstretching its balance sheet to fulfill its outsized ambitions?
Or is it a story of a housing market that has weakened to the point where even the largest developer could no longer generate enough cash flow?
The truth probably lies somewhere in between both extremes, but regardless of what it turns out to be, (or how mainstream narratives spin it), most participants in the capital markets will not want to risk dealing with Chinese property developers until they can figure out an answer for themselves.
The direct consequence of this is the likelihood of bank and capital markets lending to the entire sector being severely curtailed, at least in the immediate future. This in turn increases the risk of default for other developers, especially those who were already struggling to raise cash to meet their debt obligations; Evergrande’s problems, and the fixed income market’s reaction to it, has now become everyone else’s problem.
This would be the first instance of Evergrande’s financial contagion, and because of how large the Chinese housing market has grown, can potentially represent a tipping point for global markets.
To be continued…
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