Last Thursday, Evergrande was downgraded to “restricted default” by the credit rating agency Fitch, due to the company not meeting its offshore bond obligations. This was scarcely surprising, given the fact that this large Chinese property developer’s liabilities had risen to roughly $300 billion this year. In this article, we’ll look at what triggered the crisis, how investors feel about it, and what it implies for China and the rest of the world.
How Did The Evergrande Crisis Arise?
The chain of events that led to Evergrande’s current predicament began with the Chinese government’s policy of granting property developers easy credit. Companies like Evergrande, took advantage of the loan available to aggressively buy land around the country. This resulted in a quick upsurge in land prices, which was then followed by a corresponding rise in real estate prices.
To address this issue, the Chinese government implemented the “Three Red Lines” limit, which allows enterprises to grow their annual debt by 15%, 10%, 5%, or 0% depending on the number of red lines crossed.
The policy was aimed to improve the financial health of the Chinese real estate sector through forced deleveraging. The regulators are to assess the developers’ finance situation against these three criteria.
- Liability-to-asset ratio (excluding advance receipts) of less than 70%
- Net gearing ratio of less than 100%
- Cash-to-short-term debt ratio of more than 1x
If the developers fail to meet one, two, or all of the ‘three red lines’, regulators would then place limits on the extent to which they can grow their debt.
To simplify the implications of the policies, China’s authorities created a color-coded scheme, which is broken down as follows:
According to these rules, Evergrande was ineligible to incur any new debt. During the property boom time, the company took on significant sums of debt to fund its development attempts, but it eventually found itself unable to satisfy its obligations. This problem was further exacerbated when home sales in China fell precipitously during the pandemic.
Investor Sentiments – What The Future Holds?
Global investors are concerned about this scenario since the Chinese government has failed to make any significant communication about how it intends to handle it. The notion that the government will eventually step in to bail out their biggest enterprises in the event of a catastrophe was a major reason corporations like Evergrande attracted investments. Evergrande has already begun a lobbying campaign for more state support to help it avoid operational collapse.
The failure of Evergrande might trigger events that have ramifications for investors globally. Banks would be saddled with a mountain of unpaid loans, suppliers would lose money, and customers would be left with unfinished homes. This could lead to a loss of investor trust in the Chinese real estate sector, resulting in disinvestment and additional defaults. Real estate is also a significant element of Chinese household investments. Most retail investors would lose money if the market crashed.
Currently, the primary concern for the government is to ensure that customers get the property that they paid for. However, there have been claims that the Chinese government is seeking to assist Evergrande in resuming normal operations. Steps like these could eventually assist to restore investor confidence and de-escalate the crisis.
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