For the past week, you have probably heard the name "Evergrande" a thousand times. So if you're still wondering what that is, we're about to break it down.
I've split this newsletter into two sections.
In the first section, we will talk about the events that lead to the current situation. In the second section, we will discuss possible outcomes from the crisis and what that would mean for the financial markets.
To connect all the dots, let's first start with some info regarding Evergrande as a company.
What is Evergrande?
The company was founded in 1996 in Guangzhou, China, as a real estate developer. Apart from housing, the company has invested in electric vehicles, sports, bottled water, and many more industries. Currently, it is the second-biggest real estate developer in China, owning more than 565 million square meters of development land and employing over 200,000 people. One of the reasons it got so big is because of the housing boom (urbanization) in China, which started in the early '90s and continues in the present day.
Evergrande’s Current Situation
In the past years, we saw a slight decline in residential sales leading to lower income for Evergrande. While their income started declining, the companies liabilities increased to a stunning 300 billion U.S dollars. With the debt increasing, the company tried to diversify in the different sectors we mentioned above, but in the end, that did not help.
Another reason why Evergrande is where it's at today is in 2020; the Chinese government imposed a "three red lines" directive on certain real estate developers to help them control the companies debt levels, thus forcing them to deleverage. The directive states that companies:
have a 70% ceiling on liabilities to assets
net debt to equity cap of 100%
equity (cash) to short-term borrowing ratio of at least one
Unfortunately, Evergrande failed to meet all 3.
As a result of this directive, Evergrande tried to sell some of its business to cover its cash shortage. The cash shortage and increasing debt started to raise concerns to most investors.
Out of that 300 billion, only a little over 30 billion is owed to banks and companies outside China. The other 270 billion is owed to domestic banks and companies.
If Evergrande defaults on its debt, the more significant impact would be for the Chinese financial system. If you're wondering what "default on debt" means, it is when a company(borrower) cannot make its timely payments, misses payments, or avoids/stops making payments on interest.
If Evergrande defaults, banks and investors, that lent money to Evergrande would lose their money.
In essence, most analysts, including me, expect the Chinese government to intervene to limit the damage from a possible default from Evergrande.
For now, the scheduled interest bond payment denominated in Yuans seems to be resolved, but no confirmations that it was paid (cash).
Another interest bond payment denominated in USD (83.5 million) also hasn't been confirmed to be paid either.
From this situation, the most affected would be countries exporting iron to China, typically India and Australia.
In the end, we can only project and guess what could happen. As many people say, "Evergrande" is too "big" to fail because it would hurt the Chinese financial system if they let it default. One way or another, I'm expecting to see this case resolved.
Its effects should be short-lived, but never underestimate an outcome where things turn entirely the opposite from what we anticipated.
Not financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Do your own research.