China Evergrande Group is a real estate developer (EGRNF) that employs 200,000 people and sustains 3.8 million jobs in related industries – it is a meaningful institution. Evergrande has embodied the “borrow and build” philosophy seen in China to support a massive and growing workforce and population. The company has grown immensely by borrowing the equivalent of over $300 billion.
Last year, officials in Beijing implemented new rules to control the amount owed by big real estate developers. These new measures led Evergrande to offer its properties at severe discounts to ensure money was coming in to keep what was ultimately a stretched business afloat. Even with these discounts, Evergrande has had trouble finding buyers for some of its assets. There have been some seriously shady happenings at the firm... strong-arming employees to provide the company short-term loans, and pre-selling an immense number of unfinished apartments have been commonplace. Now, the company is struggling to meet interest payments on its massive debt load.
With the collapse of Evergrande looking increasingly inevitable, analysts in Asia, Europe, and the United States are warning us that we will see a severe spill-over to other financial markets. Major banks have reportedly been told that they will not receive interest payments on loans due yesterday. Additional interest payments are due Thursday. The primary concern for financial players is that an Evergrande fire sale could crush prices. This could cause leveraged developers to blow up and lead to an ensuing explosion of sectors comprising almost a quarter of China’s economy.
The situation and potential for contagion spooked investors around the globe yesterday. A default by the Chinese company could spread to other parts of the economy and world. There is mounting pressure on China’s government to prevent financial and economic contagion impacts from destabilizing the world and the second largest economy. Many are saying that the Chinese government does not have an incentive to bailout Evergrande which is a private-owned enterprise.
It appears that just about every bank in China has exposure to the company, which explains the heightened contagion fears.
The repercussions from Evergrande’s prospective collapse could contribute meaningfully to China’s ongoing economic deceleration. That would have broad ramifications for global growth, inflation, and commodity prices.
While U.S. equities were lumped into the selloff and saw a broad risk-off move, it is unlikely that any direct, lasting negative impact should be seen in the U.S. If anything, it serves as a reminder for investors that regions like the U.S. with strict corporate governance requirements should be afforded a premium.
The Chinese Communist Party has disrupted its local market by incentivizing aggressive growth and interrupting corporate governance. As seen in their recent escapades in the technology and private education sectors, they will intervene when the outcome is different than the one they tried to create.
Keep in mind that we are approaching an FOMC meeting this week. It will be heavily scrutinized for details regarding a potential taper, which would have been enough to occupy investors even without the situation in China.
This is a fluid situation and will be in the spotlight for the next few days. The bottom line is this could be a week of uncertainty in the markets.
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