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Will the Evergrande crisis drag China down with it?

We've collected expert views to help explain the Evergrande crisis in China and the impact it could have on global markets and investors.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Kate Marshall
Senior Investment Analyst

Published on 14 October 2021

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

China has hit the financial press headlines recently, with concerns around heightened regulation in certain sectors and a potential energy crisis.

Investors have also faced the possibility that Evergrande, China's largest property developer, will default. This would mean it's unable to pay off its debts and risks financial collapse. As the world's most indebted property developer, there have been concerns a default could lead to contagion across global markets. It's also exposed the frailties of China's property sector.

So why can't the company pay its debts?

Evergrande had made ambitious plans. At the end of 2020, it had more than 700 projects underway. The company sells lots of its homes before they're completed and as of mid-2021, it had presold roughly 1.4 million individual properties worth about $200 billion combined.

To get to this point, though, the group's had to borrow a lot of money. Lenders now face the prospect of never getting this money back. Given the ties a company of such a size has with banks, other property companies, and investors across the globe, there have been concerns a default could spill over to global markets.

China's government has tightened regulation in the property sector in recent years and, even if it let Evergrande default, it's likely to be involved in making sure lots of these projects continue. These are projects that employ thousands of people and impact the livelihoods of citizens that have saved hard and are struggling to get on the property ladder.

We've collected expert views to help explain the Evergrande crisis in more detail and the impact it could have on global markets and investors.

This article isn't personal advice. Remember, all investments fall as well as rise in value, so you could get back less than you invest. If you're not sure if an investment is right for you, ask for financial advice.

Susannah Streeter, HL's Senior Investment and Markets Analyst

"Evergrande's debt mountain piled up as the company piled into China's hot property market. As owning a home became a Chinese dream, with huge chunks of savings allocated to that goal, Evergrande's property portfolio expanded exponentially to keep up with rising demand. It has become wracked with debt partly because of industry practice in China of pre-selling properties prior to their completion. This means the company has had to guarantee customers' mortgage loans.

The property house of cards appears to have been held up by rising prices, and once authorities stepped in to try and cool the market, and prices began to fall, there has been a domino effect on demand, with what was an ongoing pipeline of fresh revenue drying up, leading to a credit crunch and the inability to pay suppliers and other creditors.

There have been some concerns there could be a Lehman Brothers-style effect, with defaults spreading across the property and potentially financial sectors. The waves of repercussion could pull down a flotilla of smaller property companies.

However, Beijing will be keen to stop contagion in its tracks and throw a lifebelt to millions of small homeowners facing financial ruin. This is likely to be in the form of a staged dismantling of the group, the further takeover of unfinished assets by state companies and a debt restructuring programme, whereby bond holders would have to take a haircut, receiving a fraction of their money back.

This scenario would still be painful but not hurt as much as a total collapse of the group. But even if contagion is minimal in the financial sector, the situation is still likely to cause a further marked slowdown for China's property and construction sector and affect mining companies. Already the price of commodities like iron ore have fallen dramatically as demand for the raw material subsides, amid ongoing concerns about slowing growth in China's economy.

The additional concern is that a big slide in house prices will knock consumer confidence in China and if consumption dips, that might have a ripple affect around the world. Although for the moment, big waves crashing into investors' portfolios don't look likely as a result of Evergrande's precarious position."

Some of our Wealth Shortlist Asian and emerging markets fund managers have also shared their views.

Martin Lau, manager of FSSA Greater China Growth and FSSA Asia Focus

"We think it is likely that the government will step in to support the Evergrande situation because, directly and indirectly, property accounts for almost 25% of China's GDP (gross domestic product). Historically the government has intervened in the sector notably around property prices, with the consequence that prices over the last 10 years have traded in a narrow range. We feel it is unlikely that they would let property prices collapse.

The government has appointed auditors and will form a debt restructuring committee. There will likely be a wind down process whereby we expect assets to be sold in an orderly process. Overall, we do not believe the government will be too aggressive under the current circumstances and is more likely to ease financial conditions.

In terms of spill over to other emerging markets, whilst in the short-term sentiment might be affected, we don't anticipate contagion (although we note there are other developers in China that are highly indebted). Commodity prices are being affected currently, although it is worth noting that the property sector in China is still growing.

We currently invest in property developer China Resources Land, which is managed well, and we expect to benefit from the fall of Evergrande. More broadly we take a conservative approach, focused on companies with the potential to grow earnings sustainably over the long run that don't take unnecessary risks in the pursuit of short-term gains."

Jason Pidcock, manager of Jupiter Asian Income

"With high debt levels and growth slowing, I believe China has many of the hallmarks of an economy heading for a recession.

The property sector could pose economic risk – Evergrande has signalled at least partial default and accounts for $300bn of debt. China's residential property sales declined by 17.6% year-on-year in floor space terms and 19.7% year-on-year in value terms in August. The ongoing trend is making life difficult for the most cash strapped developers and Provincial governments who depend on the sale of land to developers as their major source of revenue. Property developers are already offering rebates in lower tier cities, without any real success.

Many people have compared Evergrande to the Lehman Brothers crisis and said this is not as bad as that was. That said, it's still bad and only one of the headwinds facing China right now. For example, the government has been tightening regulations for a number of different sectors, while China is becoming more politically isolated.

The weighting in China in my fund has continued to drop (currently 3.7%). I believe there are other nations to invest in in the Asian region with more conducive political systems. The fund currently has no exposure to the residential property sector in China or the domestic banking system. There are currently three Chinese consumer staples companies in the fund, which are financially strong and have attractive dividend yields."

Leon Eidelman, manager of JPMorgan Emerging Markets

"[China's] real estate sector has always been highly regulated given the large role it plays in the economy and has tended to go through cycles driven by periodic regulatory tightening. However, regulations have evolved over the last two years in order to lower macroeconomic risks. This is in line with our view that China is prioritising economic and social stability.

We believe the current issues the sector is facing are company specific, made worse by regulatory tightening. The government is trying to force SOEs (state-owned enterprises) to be more careful in managing risks and so defaults may be allowed. That said, we believe these would be relatively 'orderly' without triggering systemic risk. In order to contain spill over effects to the system, the central government is likely to ask local governments to inject capital or ask other developers to perform 'national service' by taking assets from developers that are facing liquidity issues.

A number of developers have faced liquidity stress this cycle. However, even the largest companies at risk have a relatively small portion of total corporate debt in the system and most of the debt is backed by land assets. Currently the government is prioritising the smooth delivery of apartments that are already sold to ensure there are no complaints from the public and confidence in the sector is not impacted.

In summary, we do not think the sector faces systemic risks – highly indebted developers will gradually sell their assets with support from central and local government where necessary. Broader changes in the regulatory environment could continue for some time and we will continue to monitor earnings growth expectations for the impacted sectors and companies. There are also sectors that are less impacted by the regulatory changes or even enjoy more policy tailwinds, such as semiconductors, software, renewable energy and electric vehicles."

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