The Evergrande crisis, slowly unfolding in China, has already sent shockwaves through both domestic and international markets. This crisis has the potential to have international aftershocks and is a textbook example of bad long-term policy, so it makes sense to study it and apply its lessons to our own economies.
Evergrande Group, one of China’s largest property developers, had already begun its downward spiral in 2020. Regulators had tightened borrowing rules for developers, mainly due to excessive risk-taking in the real estate sector. These regulations included the introduction of the “three red lines” policy, which tried to limit developers’ excessive debt levels. Evergrande, which had aggressively borrowed money to fund its real estate projects, found itself straitjacketed with these new regulations.
The company was highly leveraged, with a net debt of $300 billion as of June 2021, a major portion of which was due that very year. Evergrande had also pre-sold a large number of properties before their completion, leaving numerous homebuyers high and dry. As a result, the company’s shares tumbled, and credit rating agencies swiftly downgraded its rating. The Evergrande crisis then reached its peak when the company officially defaulted on its bond payments, triggering shocked reactions both domestically and globally.
The International Impact of Evergrande
The Evergrande crisis has had major international repercussions. One effect has been on the cryptocurrency market. Bitcoin and Ethereum, two of the most famous cryptocurrencies, experienced steep declines due to concerns about a potential default in China. Also, the price of gold, considered a safe-haven asset, ballooned as investors sought refuge from uncertainties stemming from Evergrande’s insolvency.
Global stock markets were not immune to the crisis either. The US stock market, including the S&P 500 and Nasdaq, all saw steep drops, with giants like Microsoft, Alphabet, Amazon, Apple, Facebook, and Tesla being among the biggest losers. The Japanese stock market also took a hit, with the Nikkei 225 posting its largest one-day decrease that quarter. This downturn was particularly challenging for Japanese companies with operations in China.
Domestic Effects: A Shaky China
The Evergrande crisis has had deep effects on China, too. The real estate sector is the cornerstone of the Chinese economy, contributing around 30% of the country’s total GDP. Furthermore, about one-third of local government revenues are also generated from land sales. The Chinese economy’s heavy reliance on the real estate sector made it very sensitive to fluctuations in the market.
The government’s various regulations to limit developer leverage and curb speculation have affected the financial stability of local governments and the wealth accumulation of households. The downturn in the property market has contributed to a broader slowdown, with China’s growth decelerating in the third quarter of 2021. The government’s intention to curtail excess borrowing and speculation in the sector had severe unintended consequences
Consumer confidence has also been eroded due to rising unemployment and falling property values, leading to decreased demand for new homes. This has exacerbated the economic challenges facing China. China’s interconnectedness with the global economy also meant that the Evergrande crisis was fanned by global demand weakness as well.
The Long Way Out
As China grapples with the deepening crisis, its policymakers face the delicate task of balancing financial discipline with the imperative of maintaining economic growth. The challenges of rectifying imbalances in a sector that has long been a driver of China’s growth, government revenues, and household wealth are infinite.
The Evergrande crisis serves as a cautionary tale for regulators, demonstrating the consequences of excessive borrowing and speculation in real estate. For China, the path forward will likely involve addressing the underlying fundamentals of the real estate market, bailing out local governments, and prudent financial management and regulatory oversight.
