If you’ve been tuning into any financial news outlets lately, chances are you’ve been hearing the name “Evergrande” floating around as the reason for last week’s market volatility, with many comparing the company’s imminent collapse to that of Lehman Brothers, the American financial institution who’s bankruptcy kicked off the 2008 financial crisis. We wanted to take some time to quickly communicate why headlines are focused on this company, and why investors are worried.
What is Evergrande?
Evergrande is a large Chinese company with over $330B USD in assets, representing roughly 2% of the country’s GDP output. While they have investments in a wide array of businesses, including electric vehicle projects, health care companies and even theme parks, they are first and foremost a real estate developer, standing as the country’s second largest builder of properties.
Why are they in the news?
Thanks to the Chinese government’s recent crackdown on leverage, the company has run into a cash problem. After years of borrowing extensively and using new customer down payments to fulfill older orders, they are now no longer allowed to borrow new money. This has caused them to fall behind on their debt payments, including a sizeable $83.5M USD payment owed last Thursday. The company also has a sizeable operational obligation, with an estimated 1.5M deposits outstanding for properties not yet delivered. With the company struggling to generate cash from these assets and unable to convince new customers to pre-order more properties, they are experiencing a drastic liquidity crunch, with the majority of their assets being tied up in incomplete or desolate properties.
Why did markets fall?
Even though Evergrande only sells properties within China, some are concerned that a default could lead to global contagion, where companies relying on Evergrande for payments default on their own obligations, leading to a domino effect of other defaults and asset sales that span outside the country’s borders. Not only might this cause financial institutions with direct exposure to slow down their lending activity, but we could likewise see a sell off in the stock market as assets are sold to meet liquidity needs.
Is this Lehman Brothers 2.0?
Probably not. Yes, we may see a global impact from Evergrande’s collapse, however China is simply not as intertwined into the global economy as the US was back in 2008. The country has blocked out foreign investors from a number of sectors (with heavy restrictions in the real estate space) and has tried over the years to isolate foreign influence over its nation. Compare that to the United States, the financial hub of the world, and it is clear that we do not face the same degree of exposure as we did leading up to the real estate crisis. Furthermore, while the Chinese government has signaled that they don’t plan on bailing out Evergrande, there will likely be attempts to control the fallout within its borders; the country has already injected 90B yuan ($14B USD) into the banking system to help with liquidity, and may go so far as to pay company employees directly to finish incomplete developments. As a quasi-communist nation, the government has a lot of control over how things play out.
That being said, this does not mean the situation is not important. Given Evergrande’s size and the fact it owes money to a number of foreign lenders, we could very well see further market volatility. Unfortunately, it is near impossible to quantify the sort of impact contagion would have on the stock market, and given that we left our crystal ball at home, we have no way of knowing how bad (or how uneventful) things might get.
What we do have, however, is time. When you avoid speculating and instead invest in solid businesses who themselves are not drowning in obligations, you are well-equipped to wait out most storms. We have incomplete information about Evergrande, so the best course of action as always is to focus on the long-term and avoid getting wrapped up in the emotions of the market. Evergrande may very well prove to be a material problem, but it is just the latest fixation of the markets, and as with every other event in financial history, it too shall pass.
As always, we are available to address any concerns you may have.