Evergrande – An Asteroid to be Rescued by a Red Star?

The giant group from Guangdong, P.R. China, is in serious trouble recently. The company was created in 1996 in the chinese city of Guangzhou by Xu Jiayin, back then by the name of “Heng Da Group” and has liabilities of 310 billion dollars – equivalent to the entire public debt of Portugal.
It was originally just a real estate market and became one of the biggest chinese real estate companies in forefront with other two (“Vanke” and “Country Garden”) but in the course of the last few years the company expanded its business to other fields such as sports – acquiring the soccer team “Guangzhou F.C.”- it invested in electric vehicles, a few theme park brands, ownes “Evergrande Health Group”, and was involved in dairy and mineral water businesses.

To understand the huge amount of debt involved, we need to understand the chinese real estate market: China has one of the highest home ownership rates in the world (89.68%) ranking 9th and behind countries such as Croatia and Vietnam, with real estate accounting around 75% of total household wealth – in Portugal home ownership rate is of roughly 74%.

The obsession with real estate in China is due to some reasons: it is an amazing investment with house prices increasing year after year, mostly in the first tier cities, since the 2000’s – this compels a lot of chinese to put all their eggs in the real estate seeing properties as “nest eggs”; due to the steady market and increasing prices real estate is far more attractive than companies bonds and Chinese stock market which are very volatile and the yields are very low; the preference for fixed assets also comes from a belief that something that is physically fixed somewhere cannot be taken away from you and it is far harder to be cheated and lose all the money invested than if someone could just take your money and run away leaving you with nothing – if someone sells you an apartment, you know that the apartment is there and nobody can run away with with like they can do with money; also due to culture and tradition a man must own a property if he intends to marry and the woman’s parents are usually very demanding about this condition.

The increasing demand in real estate led companies like Evergrande to build more and more houses quickly. The problem is that it is becoming more difficult for developers to raise money to build more houses as it is for the investors to raise enough money for downpayment to acquire real estate – with first buyers having to pay around 30% to have access to loans.
With housing market slowing and debt increasing it also increased the concerns on whether the company’s debt is sustainable, being considered more risky by the investors demanding higher interest rates. This vicious cycle was agravated last year when the company offered 30% discount on its properties and by that time a leaked letter was sent to the Chinese Government asking for support.

Due to the increasing demand for real estate private investors “loan” money to companies like Evergrande, the companies picks the money to invest and in return offers 6% of dividends and these bonds can also be traded in the called bond market.
In the last weeks the company has been notifiying investors that they will default on over 300 billion Dollars of bonds and these notes are the last the company will want to default because it is sending the clear message that with the money it picked from the investors they can no longer finish the over 2 million homes they are building in China and return the money plus the dividends to them and they will lose the money invested.
The domino effect means that defaulting the construction projects it will affect all the companies and personel involved in the projects such as constructors and workers that will lose money and jobs as will affect the private investors – some of them companies like banks, insurance companies, etc, that loaned money to Evergrande – and that depend on that money to also pay their liabilities and debts.

So what can the company do? Since real estate is an illiquid asset that cannot be quickly or easily converted into cash for their fair market value and the company holds real estate assets it needs to get rid of it, it needs to sell it to convert in money, but in the real estate market cooling down and due to the lack of trust of investors that company would have to firesell the properties, which means that would have to sell the properties at low price pulling the real estate market prices down, affecting the line of supply and demand with a lot more real estate available to buy and at very low prices.

Another possibility would be a corporation bailout made either by a company or bank institution with the size comparable to the ones that were initially interested in Lehman & Brothers in 2008 (Barclays and Bank of America) or made by the government (government bailout).
In fact the envolvement by the Chinese Government would probably be necessary because if there is no corporation interested in bailing out Evergrande millions of people will lose jobs and money – discontentment by population is something China does not need namely when still fight off the pandemic with “zero case” policy.
Backing companies with cash is also a “tradition” in communist China with the Government injecting money in chinese companies to rescue them, support their growth or to fight foreign competitors.
On the other hand if the government decides to intervene it will raise its public debt and in certain way things will be kept in the way they are which will not stop property speculation and the credit expansion and would contradict the Government efforts of the last years for transparent debt market.

But doing nothing can also be dangerous because if the company crashes down it will also have other effects in economy mainly the so called “wealth effect”, which means that when households become richer as result of a rise in assets value and, in this case, feel their property price is higher they will spend more money, invest more and stimulate the economy, with more economic activity and consequently with economic growth; and when households become poorer as result of decline in assets value they will save more in banks, spend less and will not stimulate economic activity.

The Government has not made any comment or public announcement yet but it will be interesting to follow what will suceed in the next weeks and if there will be a corporation or a government bailout for Evergrande; if it will collapse or even it if “it is too big to fail”.

The content of this information does not constitute any specific legal advice; the latter can only be given when faced with a specific case. Please contact us for any further clarification or information deemed necessary in what concerns the application of the law.