Global financial markets have been on high alert in recent weeks as cash-strapped Chinese property giant Evergrande, faced several key tests to meet its respective debt obligations. At face value, Chinese property developers' debts appear big enough to crash the whole national economy. Nevertheless, there are still several factors which could possibly limit the real estate downturn and the threat of global financial contagion.

According to the financial group Nomura, the total combined debt of China's major property developers is now estimated at more than $5 trillion. Specifically, around twenty of the top thirty property firms by sales in China, have breached at least one of three debt redlines implemented by the Beijing government to control and limit real estate speculation.

Indeed, the reason Beijing created the debt redlines was to prevent a property crisis similar to the one in the United States (US) in 2008. Although a crash would undoubtedly have a negative impact on people’s lives, the predominant intention behind the creation of these redlines was to limit the shock to the wider financial system.

Apart from Evergrande, Country Garden, which is the largest property developer by sales, and China Railway Construction Corporation, which apart from properties, has built much of the country’s high-speed rail network and subway systems, are also currently faced with an elevated level of liquidity issues. In addition to Evergrande, other property giants such as China Railway Construction Corporation, which both breached all three debt redlines, have struggled to offload assets to help repay massive piles of debt following the recent spike in interest rates.

From a macroeconomic perspective, with property being one of China’s main economic growth drivers, contributing to circa 29% of the country’s gross domestic product as of 2020, any major real estate crash will inevitably threaten and negatively impact the entire Chinese economy, namely from three different fronts.

Firstly, many individuals have bought properties from Evergrande even before development works began, and in the case where Evergrande goes bust, they would potentially lose their deposit money. Secondly, there are a large number of companies that do business with the property giant, such as construction and design firms, and materials suppliers. In this respect, if Evergrande defaults, these companies will be at a high risk of incurring significant financial losses, which could possible force them into bankruptcy and liquidation.

The third and harshest threat is the possible impact on the Chinese financial system. The potential and financial fallout of Evergrande would be far reaching. Reportedly, the company owes money to a large number of domestic banks and other financial firms and in the case where Evergrande defaults, banks and other lenders may be forced to start lending less. This could eventually lead to what is known as a credit crunch, where companies struggle to borrow money at affordable rates.

The possibility of a credit crunch would be very negative news for the world's second largest economy after the US. Companies in general may find it problematic to borrow for growth purposes, and as such may prevent such companies from continuing operating. A credit crunch might also limit foreign direct investment, as China becomes less attractive for foreign investors.

Although the government has refrained from rescuing Evergrande thus far, it has the capacity to prevent a total collapse. In comparison to the 2008 financial crisis, the US government had no prior experience of rescuing the housing market before and as a result was reluctant to bail out large companies such as Lehman Brothers.

The significant potential fallout of such a heavily-indebted company, has led a number of analysts to argue that Beijing may possibly step in to rescue it.

Importantly, this does not mean that China is reprieved from a property bubble. However, the collapse of Evergrande which employs 200,000 people and indirectly sustains three million jobs, is likely to be carefully managed by Beijing to limit the fallout to the wider economy.

The company has so far avoided default by meeting two debt obligations at very late stages. Another deadline for payment falls this week. Specifically, close monitoring is imperative in this regard to see whether Evergrande will be able to meet their respective financial debt obligations once again. Undoubtedly the common prosperity push might need to be delayed given the circumstances. Let’s not underestimate the possible trigger of social unrest which equity value of existing home owners continues to decline. In simple terms, the wealth effect is now being questioned and this does not augur well.

Disclaimer: This article was issued by Andrew Fenech, Research Analyst at Calamatta Cuschieri. For more information visit www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.