Evergrande is a Lehman-style lesson for China

Global markets faced a sell-off on Monday as investors worried that the collapse of a major Chinese property company could have a contagious effect and undermine financial stability in the world’s second largest economy.

A large property developer in China, Evergrande, which has exceptionally large debts, is struggling financially in the wake of government efforts to cool a hot property market. Concerns over the company’s sustainability climbed a notch after credit ratings company S&P Global Ratings said in a report this week that the property developer was close to defaulting on debts as soon as Thursday.

Investors are fearful that the Evergrande situation is a sign of broader troubles in China’s property market, which shows signs of being a bubble – economic jargon for when asset prices have risen sharply and reach a level that seems unsustainable. When these bubbles burst, it has an effect that is often termed a crash: a sharp and sudden fall in asset prices.

That’s a big concern for investors who are exposed to China’s assets, but also for the global economy, given China’s relative size. The country is expected to account for a fifth of global growth from 2021 to 2026, according to forecasts published by lender of last resort the International Monetary Fund in April this year.

Property companies’ woes have caused particular alarm because the real estate sector accounts for a significant amount of China’s economic output. Investment in real estate accounted for 13 per cent of China’s GDP in 2018, according to the US Department of Commerce Bureau of Economic Analysis. Historically, investment in the sector has accounted for only around 5 per cent of GDP in the US.

In 2020, economists Ken Rogoff and Yuanchen Yang calculated that a 20 per cent fall in housing sector activity could lead to a 5-10 per cent fall in GDP.

Some economists and market analysts vehemently reject the idea that this is a rerun of the 2007 financial crisis, but that doesn’t mean it isn’t a signal of serious problems ahead. A bumpy ride or even a crash in China’s overcooked construction and property market would hasten a slowdown in the country, which has already failed to bounce back from the pandemic as rapidly as some predictions suggested.

It’s not yet clear what steps the Chinese government will take, but its central bank has already stepped in to boost liquidity, ensuring cash can keep flowing through the financial system – a sign that it may have been trying to calm investors’ and bankers’ nerves.

If Evergrande does default, pain will initially be felt by larger financial companies and banks who hold assets linked to the firm, Tommy Wu, lead economist for the Asia Pacific region at Oxford Economics told The Independent.

“There are different stakeholders for the Evergrande situation. There are homeowners who bought houses from Evergrande, there are retail investors who bought products from Evergrande; the other stakeholders would be the banks, bondholders and suppliers,” Wu said.

The top priority, as far as the government in Beijing is concerned, is mitigating the impact of Evergrande’s potential downfall on homeowners, Wu added. But for the rest of the world, the question Wu and other economists are wrestling with is whether any government intervention manages to stop a wider “fire sale” in China’s property sector.

S&P believes that China’s government will only step in if there are signs of wider contagion that is “causing multiple major developers to fail and posing systemic risks to the economy”, not if the impact is limited to Evergrande alone.

“We think that the government will engineer a managed restructuring, even though it’s not going to bail out Evergrande and investors,” said Wu.

Some economists are stopping well short of calling this China’s “Lehman moment” – Lehman Brothers being the US bank whose collapse augured wider turmoil during the financial crisis. Such a narrative is “wide of the mark”, according to Simon MacAdam, senior global economist at Capital Economics. While any situation involving debt and property brings back troubling memories for investors, this is a different kind of problem in a different kind of market.

“The closest parallel is [South] Korea in 2003, rather than Lehman,” Freya Beamish, chief Asia economist at Pantheon Macroeconomics, told The Independent. “The ultimate difference is from a global perspective: China is not at the centre of the global financial system, whereas the US very much was and is.”

In South Korea, credit card lending exploded in the late 1990s and early 2000s. This flipped the financial behaviour of households from determined saving towards spending and accumulating debt. Credit card purchases as a percentage of consumption rocketed from 15.5 per cent to 24.5 per cent between 1999 and 2002.

The parallel matters because China faces a complex web of financial leverage created by a boom in its property sector, Ms Beamish said. That will take time to unravel and may even prove impossible to measure over time.

Excess savings – a problem in South Korea in the late 1990s and a well-documented issue in China, which has had one of the highest rates of savings relative to GDP in the world in recent years – can help fuel bubbles, according to some economists including former chair of the US Federal Reserve, Ben Bernanke. He believes the global savings glut built up in 1996-2006 helped to fuel the 2007 financial crisis.

Beamish thinks a similar effect may have happened in China in recent years, where a wall of companies hungry for money has bumped up against another wall of money built from household savings. The result: a property and construction bubble.

“In that sense, the driver of these Evergrande woes is the same as that of the Lehman moment, but China and the US have very different roles in the global financial system so the outcome won’t be parallel.

“For the real economy, the threat is that there’s an acceleration of fire sales, not just by Evergrande but by other property developers. These guys have been evergreening for a long time. It’s an endemic phenomenon within the property sector,” Beamish said. The term “evergreening” is often used in finance to describe companies avoiding default by taking on more debt.

“It all smacks of a Ponzi scheme. The concern is that the Chinese authorities don’t do enough in the first instance to properly stop this, because they can’t quantify the problem, because it’s such a complex web,” she added. This lack of clear statistics spelling out who, exactly, is exposed to what in China’s property sector is another reminder of the confusion after Lehman’s collapse.

If, as Beamish and others expect, Beijing steps in quickly to try to mitigate and slow down any wider deterioration of the property sector, it can dampen the wider impact on confidence in financial markets, stopping broad-based fire sales in the real estate market and “nasty” impacts on household finances, she said.

Evergrande’s situation is not ultimately a sign of a financial collapse, either in China or in the wider financial system, but there are spillovers to consider.

“In terms of the contagion side of things, I think it’s mainly a China issue,” said Wu. But commodity prices, for products such as steel, iron ore and coal, are likely to be hit by a slowdown in Chinese construction, he said – even if interventions from the government, with a boost for infrastructure building, might mitigate this somewhat.

Banks such as HSBC and Standard Chartered, which make significant amounts of money from trade finance linked to Chinese imports and exports or other Chinese assets, may also be hit by a wider economic slowdown in the months ahead.

And while Evergrande is not at the centre of the world’s financial markets as Lehman was, its potential fall is a symptom of a wider concern. Even if a crisis is avoided – through a state-led restructuring of Evergrande – Chinese construction is in decline, said MacAdam, slowing China’s GDP growth to 2 per cent by 2030 in his view. It’s also, as Lehman was, symptomatic of a savings glut, and a subsequent bubble.

Put simply, said Wu, “It makes the outlook a little gloomier now.”