How Can Evergrande’s Contagion Occur? 4
The series of events described in parts 1 to 3 of these articles about Evergrande’s unfolding saga represent one of the worst case scenarios, if not the worst case scenario. Chinese authorities can intervene at any point in the sequence of events, which will naturally alter the course of future events. However, where and when they choose to intervene is of critical importance.
Intervening early, before the real estate defaults snowball to engulf the banking system will obviously lead to a much less destructive outcome than waiting to step in after banks themselves get dragged into the vortex of defaults.
Of course, it is entirely possible for contagion to not materialize even without the intervention of Chinese officials. This would be contingent on the majority of Chinese real estate developers being well capitalized enough, i.e. not carrying large amounts of leverage; and having large enough balances of cash and very liquid assets to see them through the initial storm.
This scenario, while possible, remains unlikely for three main reasons. Firstly, developers are already defaulting, and have been doing so since the first quarter of 2021; the sector is simply too overleveraged to withstand the government’s new policy paradigm:
“houses are built to be inhabited, not for speculation” – Xi Jinping
Secondly, fear spreads very quickly in markets and often leads to participants all rushing for the exit at the same time, with little regard for rationality. Such herd behavior leaves little room for nuanced and careful consideration when making investment decisions, which increases the risk of indiscriminate selloffs across the entire Chinese real estate sector.
Finally, there remains a sizable risk of the contagion spreading through local governments, who will see revenues from land sales fall significantly as the real estate market plummets. This would put those who are overleveraged, and/or reliant on such revenues to fund their municipal spending, in an untenable position. Considering the arcane and impenetrable web of local government financing and over-indebtedness in China, Evergrande’s default might prove to be the straw that breaks the camel’s back.
Ultimately, while the central Chinese government has, and probably will, intervene in some form or other over the course of the Evergrande/real estate saga, it is worth remembering that fear is almost impossible to contain.
Regardless of how competent or centralized a government is, and no matter how much confidence investors and traders place in a government’s ability to control financial contagion, history has proven time and again that indiscriminate selling begets more indiscriminate selling.
As such, if the Chinese government intends to intervene at some point, as a good number of market watchers believe, they need to do so at the right time – just when overleveraged real estate companies have felt enough pain, but before too much fear pervades the markets and spreads the contagion to banks and local governments. Needless to say, this course of action is fraught with risk.
After all, few things spread as quickly as fear (not even Covid).
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