In 2008, Lehman brothers, then a systematically important financial institution, faced an unprecedented loss due to the continuing subprime mortgage crisis. Despite raising $10 billion worth of equity, following the issuance of preferred stock and through other investors, its large mortgage securities portfolio and high degree of leverage made it susceptible to deteriorating market conditions. Lehman Brothers filed for bankruptcy on September 15, 2008.

China, potentially, faces a similar scenario with Evergrande Group – the country’s second-largest real estate developer by sales.

China’s real estate industry has, over recent years, and on the back of rapid urbanisation across the world’s most populous country, witnessed substantial growth. Today, it accounts for more than a quarter of China’s economic activity. That said, Evergrande’s survival, it being one of the largest players in the market is crucial.

Credit markets have, following Evergrande’s woes, felt the pinch.

Dollar-denominated credit in China, particularly real estate, have for quite some time posed as an attractive opportunity to investors in search for a higher yield. Also, it plays a central role within the said Emerging Market segment.

Evergrande’s metrics inferior to those set by the CCP

Evergrande, consequent to its relatively low liquidity and thus insufficient cash levels, entered into a vicious cycle to complete its projects through proceeds generated from the sale of units from that same ongoing project. Sales have in August 2021 fell by 26 per cent year-on-year, despite heavy discounts, worsening an already tense situation. Metrics, notably those introduced by Chinese Communist Party (CCP), continued to deteriorate.

The CCP – the founding and sole governing political party of the People's Republic of China (PRC), led by Xi Jinping have in August 2020, following a meeting that occurred against a backdrop of growing debt levels, rising land prices and booming sales, imposed ‘three red lines’ guidance on selected developers, which may pose systemic risks to the nation’s financial ecosystem.

Given its size and thus economic importance, the set policy threatened southern China's Guangdong Province based; Evergrande Group, which sells apartments mostly to upper and middle-income dwellers.

The set of strict financing rules include: Debt-to-Asset ratio below 70 per cent, Net debt-to-equity ratio below 550 per cent, and Cash-to-short-term debt ratio of more than 1x. Should the selected real estate developers fail to meet one, two, or all of the ‘three red lines’, regulators would then place limits on the extent to which they can grow debt. Albeit Evergrande’s efforts to raise cash to honour its interests through property sales, thus reducing their net leverage, metrics do not conform.

Bankruptcy may prove detrimental to the economy

Evergrande’s total liabilities amount to approximately $310 billion, while interest-bearing debt amount to just over $120 billion. The latter figures, although typical given the nature of the industry (typically highly-leveraged), are worrisome given the hundred plus number of banks and other financial institutions involved. This, certainly justifying Beijing's concerns, fearing a crisis in the financial system in the event of Evergrande's bankruptcy.

In addition to the number of banks and financial institutions involved, over 8,000 companies work with the real estate group, and thus have debts or orders with it. All these companies would be affected should Evergrande default. Moreover, the impact can directly hit households and workers. In 2020, the said real estate developer employed approximately 140,000 workers and indirectly, have created 3.30 million jobs. Two million households have also already paid for their homes before they are built. In the event of a collapse, the latter group may, inevitably, experience major complications.

Being well aware of its economic importance, Evergrande’s executives are using it as a lever to blackmail the CCP. Indeed, the real estate group published a letter on August 24, explaining at length that if the state does not intervene, Evergrande will drag everyone down with them.

The property market has been a major driver of economic expansion in recent years, particularly in the aftermath of the coronavirus outbreak. A slowdown in the sector may have a negative outcome on the overall economy. With the latter in mind, we expect Xi Jinping’s government or The People's Bank of China to step in to mitigate the impact, possibly in a restructuring phase, should Evergrande default on interest payments due on their Dollar-denominated debt. It is worth highlighting that the Chinese real estate group have met local debt deadline today (August 22), allaying some market concerns.

Contagion threat hits credit markets

The dollar-denominated Chinese credit market, for quite some time posing as an attractive opportunity to investors in search for a higher yield, have in recent weeks, consequent to policy changes and the cash crunch at China’s Evergrande Group, built a narrative that a wide swathe of Chinese assets are under threat.

The threat stoked contagion fears in the real estate sector. Chinese real estate developers, even those who enjoy a higher credit rating and thus are more able to repay the debt owed, traded significantly downwards.

While the said moves witnessed within the industry may for some investors, in search of higher yield and thus higher risk tolerance, pose an opportunity, we recommend caution, with a proper evaluation of the industry climate considered imperative at this juncture. Chinese real estate developers, even those who’s financial health is in-line with the ‘three red lines’ policy, may face difficulties or end up paying a premium to refinance their debt, should the need arise.

Disclaimer: This article was written by Christopher Cutajar, credit analyst at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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