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[Burning Issue] Chinese Evergrande Crisis

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Context

  • China is witnessing one of the most challenging economic crisis in its history.
  • The real estate market which accounts for nearly 30% of its GDP has come crashing down in the past 1 year.
  • Property sales plummeted by 72%, 1000s of people are protesting in 86 cities, and now there is a banking crisis where banks have started freezing the accounts of the Depositors.
  • In its heaviest crackdown on depositors, it has deployed tanks against the protesters. 

And in spite of all this trouble, experts say that this is the just beginning of one of the worst economic crises that is followed in China!!  The question is-

Chinese Evergrande Crisis: A backgrounder

What is Evergrande?

  • Evergrande is a Real Estate company which currently owns more than 1,300 projects in more than 280 cities across China.
  • The broader Evergrande Group now encompasses far more than just real estate development.
  • Its businesses range from wealth management, making electric cars and food and drink manufacturing.
  • It even owns one of country’s biggest football teams – Guangzhou FC.

What is the crisis?

  • Chinese property giant Evergrande, whose liabilities exceed $300bn (£228bn), failed to meet interest payments to international investors.
  • That prompted Fitch, an agency that rates companies’ financial risk, to declare Evergrande in default.
  • The crisis has spooked investors who fear contagion across China’s property and banking sectors.
  • Fitch, whose risk ratings are closely followed by major investors seeking to deploy billions of dollars, said it contacted Evergrande about the non-payment but received no response.

How did it land itself in trouble?

  • Evergrande expanded aggressively to become one of China’s biggest companies by borrowing more than $300bn.
  • Last year, Beijing brought in new rules to control the amount owed by big real estate developers.
  • The new measures led Evergrande to offer its properties at major discounts to ensure money was coming in to keep the business afloat.
  • Now, it is struggling to meet the interest payments on its debts.
  • This uncertainty has seen Evergrande’s share price tumble by almost 90% over the last year.

Why would it matter if Evergrande collapses?

There are several reasons why Evergrande’s problems are serious.

  • Loss of public money: Many people bought property from Evergrande even before building work began. They have paid deposits and could potentially lose that money if it goes bust.
  • Loss to investors: There are also the companies that do business with Evergrande. Firms including construction and design firms and materials suppliers are at risk of incurring major losses, which could force them into bankruptcy.

Economic impact on China

  • Huge dependence on a single company: Evergrande is an enormous company embedded across China’s financial system and economy, which relies heavily on the property for growth and jobs.
  • Credit crunch in the economy: If Evergrande defaults, banks and other lenders may be forced to lend less. This could lead to what is known as a credit crunch, when companies struggle to borrow money at affordable rates.
  • Withdrawal of foreign investments: Companies that can’t borrow find it difficult to grow, and in some cases are unable to continue operating. This may also unnerve foreign investors, who could see China as a less attractive place.
  • Snowball effect on debts: In theory, a collapse could chase investors away from other publicly traded developers, setting off a chain of defaults.
  • Rise in unemployment: A collapse could also undermine the economic activity and jobs created by Evergrande and its downstream suppliers.
  • Visible bankruptcy: Cash is so short the company this summer started paying some suppliers with unfinished apartments instead of money.  

Why Chinese people are fuming over the streets?

  • Many investors have expressed concerns about the Chinese government’s lack of communication about its plans.  
  • Continued absence of a clear message from Beijing is posing notable downside risk to growth.
  • Given wide use of property as collateral for loans to companies and local governments, a deep and widespread drop in prices, however unlikely, could threaten the financial system.
  • To head off further damage, the government faces the challenge of ensuring customers get the homes they bought.

What is China’s government doing to prevent a crisis?

  • The government of the province, where Evergrande is based, said that at the company’s request it would dispatch a working group to help Evergrande manage its risks and maintain normal operations.
  • China’s central bank said it supported the decision to step in and would cooperate, while banking and securities regulators said they would work together to maintain the health of the broader property market.
  • Chinese authorities had earlier asked local governments to prepare to step in—only at the last minute—if Evergrande fails to manage its affairs in an orderly fashion.
  • This approach signals Beijing’s reluctance to bail out the debt-saddled property developer while bracing to cushion any economic or social fallout.

What exactly went wrong with the Real estate market in China?

There were two immediate triggers that precipitated the crisis at Evergrande.

  • Chinese regulators, as part of a widespread crackdown on sectors such as the digital economy and education, kicked off probes into the high borrowings of property developers.
  • To counter that, Evergrande tried selling off some of its business.
  • But a progressive slowing down of China’s property market and tapering demand for new houses crimped cash flows.
  • These two factors combined to precipitate the cash crunch at Evergrande.
Three red lines
In August 2020, in an effort to better manage the heavily leveraged sector, Chinese regulators introduced rules dubbed the “three red lines” to limit borrowing of real estate firms.
The three red lines mandate that developers maintain:
1. A debt-to-asset ratio of 70% or lower,
2. A 100% cap on net debt to equity,
3. Enough cash on hand to satisfy short-term borrowing, debts, and liabilities.

Why is the world worrying?

A collapsing property market in China has triggered alarm bells across the world.

(1) Future of manufacturing

  • It is still the manufacturing hub of the world and if its economy falters, countries around the globe would suffer from slower and more expensive exports.
  • Contract electronics and semiconductor manufacturing, where China is a global leader, had already stalled various sectors such as auto, consumer electronics and more due to Covid-induced supply bottlenecks.
  • This would only go up further in an economic crisis.

(2) Future of BRI Projects

  • China is also the global creditor of the developing world. Developing countries dependent on China for infrastructure projects, would be hard-hit.
  • The Xi-government has sponsored numerous projects under the Belt and Road Initiative.
  • Currently, BRI projects are valued at over $1 trillion across 139 countries around the globe. These building sites, highways, power generation plants and so on could be left unfinished.

(3) Disburse of finances

  • China’s extended property boom that started in the mid-1990s has now ensured that nearly three quarters of the country’s household wealth is locked up in housing.
  • An impending collapse at the biggest real estate company could have a serious knock-on effect on the entire economy.
  • It could drag down growth and potentially setting off a cascading impact that could singe the global commodities and financial markets.

Impact on India

  • India’s buoyant iron ore exports, much of which is headed to China, could also see an impact if the twin crises in China triggers an extended slowdown in the Chinese real estate market.
  • In India’s stock markets, the metals segment, which has been surging since the start of the year and appeared to show signs of overheating.
  • Analysts view this more as a short-term correction, but there could be an extended impact if the crisis in China were to remain unresolved.
  • And there could potentially be a sustained impact on global growth prospects, dampening the nascent recovery that is underway in markets such as India.

Why global sentiments now are against China?

  • Aggressive expansion: In recent years, China has expanded its diplomatic and economic relationships through aggressive means.
  • Covertness of BRI: It has been positioning itself as a donor of much-needed public goods through it’s the Belt and Road Initiative.
  • As China’s influence has grown, so have the number of countries concerned with its:
  • Lack of economic reciprocity
  • Dominant technological policies
  • Coercive foreign policy practices, and
  • Regional military ambitions
  • In Asia, where strong economic ties with China are critical to development, Beijing has still managed to drum up resentment for its unyielding position on territorial claims in the South China Sea.
  • Criticism of Chinese policies, both at home and abroad, has revealed the grittier side of Beijing’s diplomacy.
  • The coronavirus has only further highlighted this dynamic.

Will China collapse?

What do incidences say?

  • Freezing of bank accounts: Some Chinese banks have responded by seizing purchasers’ savings deposits, claiming they are really ‘mortgage investment products.’
  • Putting tanks over protestors: This has sparked open protests outside some banks, leading to the government surrounding the banks with tanks.

However, there is not going to be a financial crash in China. Why?

That’s because the government controls the financial levers of power:

  1. The central bank,
  2. The big four state-owned commercial banks which are the largest banks in the world (who lends Pakistan always)
  3. The so-called ‘bad banks,’ which absorb bad loans
  4. Big asset managers

Hence we can say that China is too big to collapse.

How can China achieve this?

Ans. Socialistic Autocracy

  • The government can order the big four banks to exchange defaulted loans for equity stakes and forget them.
  • It can tell the central bank, the People’s Bank of China, to do whatever it takes.
  • It can tell state-owned asset managers and pension funds to buy shares and bonds to prop up prices and to fund companies.
  • It can tell the state bad banks to buy bad debt from commercial banks.
  • It can get local governments to take up the property projects to completion.
  • So a financial crisis is ruled out because the state controls the banking system.

What are the lessons India needs to learn from the Chinese economic Crisis?

  • What we need to learn from this Chinese crisis is that investment instruments driven by mindless social norms will often cost both the people and the economy heavily.
  • In this case the Chinese definition of a well-seeded person got a ton of debt piled up for the Chinese people in spite of the sky high prices.
  • In our case in India the same thing happened with fixed deposits (FDs) because we outright considered FDs to be safe because of the social norm without understanding inflation.
  • Similarly the mindless purchase of gold is now hindering our economy so take a step back and assess whether your instruments are backed by calculated strategy or just mindless social norms.
  • The Indian real-estate sector has been stagnant.
  • If companies in the sector are to be believed, this has primarily been because of high interest rates. But what is basically holding back people are high home prices.
  • We need homes in a price range of ₹10-15 lakh for real estate to become a major contributor to economic growth, like it has been in the Chinese case.

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