Evergrande. Old memories come flooding back

It has just emerged that the bursting of the property bubble we have been discussing since 2016 has now happened, and it was not caused by a small business, but by a Fortune 500 company. The Chinese property company has announced that it may not be able to meet the upcoming maturities on the colossal $300 billion debt figure on its balance sheet. Everything seems to suggest that this won’t just be another footnote in the history books of economics; rather, it looks as though, after COVID and this, we won’t want to see sweet-and-sour chicken on the menu or in jokes.

20 September 2021 Reading time: 5.20 mins

It has just emerged that a Chinese company called Evergrande, unknown to almost all Westerners, is likely to default on its upcoming debt repayments. This news, in itself would seem insignificant were it not for the fact that not only is it a member of the select Fortune 500 club, but also because everything points to this being merely the tip of a gigantic iceberg which, despite being so far away and in a country as closed off as China, is bound to have repercussions for us. And unfortunately, this would be the second major blow, after COVID, to come from that Asian country in a very short space of time.

To understand the problem, we need to go back to the early years of this century, when easy access to credit meant that we in the West were buying large quantities of goods from China using loans from our banks.

“Towards the end of the first decade of the 21st century, China had an export-led growth model. We paid for those purchases with bank debt.”

China had become – and has remained, despite what I am about to say – the world’s factory. Consequently, China had an extremely large trade surplus, exceeding 10 per cent. In contrast, the US had a trade deficit, but this was also substantial, exceeding 6 per cent.

The credit crisis that erupted with the collapse of Lehman Brothers nipped bank-financed foreign procurement in the bud, forcing the Chinese government to shift its growth model from one based on exports to one based on domestic consumption. This was undoubtedly a full-blown change of cycle.

“By 2014, Chinese private debt stood at around 100 per cent of GDP. This was the spark that ignited the current crisis.”

At that time – and this is a very significant point – private debt as a percentage of GDP in China stood at 100 per cent, because figures of such significance would be the spark that would set the current fires alight.

But whilst the Lehman Brothers collapse and the financial crisis left us in a sorry state, it was a godsend for the Chinese, as we began to print new money as if there were no end to it in order to recover.

Quantitative easing – which I’ve explained in a video I posted – was carried out in 2011 and 2012 in a way that I usually illustrate with a DIY example. As I want to fill the holes in my garden table so it can withstand the winter, and I can’t do them one by one, I pour a large amount of oil over it to cover the whole thing. But unlike what I would do with the oil on the table – which would be to wipe off most of the excess – with the quantitative easing measures, what actually happened was that the surplus money was left in the market, meaning that many people who didn’t need the credit used it as a good, attractive and cheap investment vehicle.

«The quantitative easing programmes during the 2008 credit crisis encouraged the purchase of Chinese assets at attractive rates, thanks to cheap bank financing.»

Many Western investors saw an opportunity: they borrowed money from banks at rates close to zero and invested it in Chinese assets yielding around 6 per cent, at a time when the exchange rate against the yuan was stable. It was a perfect deal for the Chinese. We in the West took on the credit risk whilst they carried out this transformation of their economic model.

Around 2014, Western central banks began to withdraw their monetary stimulus measures, or at least part of them. They began with the famous ‘tapering’, and that was the end of the easy money scheme of buying assets here with money from there, which forced the Chinese government to take over the role of providing such credit facilities to its citizens.

As well as creating new money supply, they did so by lowering key interest rates. This not only continued to enable the country to grow at rates never before seen in the West – at least by those of us still alive today – but also led to private debt rising in 2020 from that 100 per cent I mentioned earlier to 220 per cent. In less than six years, private debt had risen by 110 per cent. And that in a communist country.

“The fact that, in a communist country, private debt can grow by 110 per cent in six years to the point where it becomes a cause for concern, at the very least, is laughable”

You don’t need to be a guru to know that when there is money to spare and you buy all sorts of things, ultimately the quality of the assets acquired is neither as good as one would wish, nor – in most cases – as one would expect. And in any case, the price paid for them is usually excessive, if not downright exploitative. But as we all know, greed is a very common deadly sin. And if this is done on an exorbitant scale, what you end up with are giants with feet of clay, such as Evergrande.

The Chinese company Evergrande is a giant in a market all too familiar to us: the property sector. It is a company with more than 200,000 direct employees and around 4 million indirect employees. With a portfolio of over 1,300 projects spread across some 280 Chinese cities, it seems they have ‘bad debts’ everywhere. In other words, assets of the sort that were bought with money that was good, attractive and cheap, but which are neither good nor cheap. As for whether they’re attractive, I’m not so sure.

“Evergrande is a Chinese property company that is all too familiar – and, sadly, easily recognisable – to Westerners”

Unsurprisingly, he had ‘diversified’ his business with a wide range of investments, such as in leisure and football. I’m sure all this will sound sadly familiar to the reader.

Ah! And I nearly forgot – just so we’re fully in the picture: we’re saddled with a massive bank debt. In this case, the staggering sum of 300,000 million dollars.

The trouble is that whilst this may well be the largest Chinese property company in trouble, there are plenty of other companies just like it in China.

But as is the case everywhere, the blame lies with several parties. The property market has skyrocketed, partly because the government has encouraged it. The policy of Xi Jinping, the charismatic Chinese president, was to encourage a major population shift from the centre of the country to new, mainly coastal cities, but many of these new cities have become ghost towns.

“China’s ghost towns have become a tourist attraction. If that were the case, it wouldn’t be a problem, but we’re going to be caught in the crossfire through no fault of our own”

The symbol of this property folly is a city called Ordos Kangbashi, in a region of China known as Inner Mongolia. This city is designed to accommodate 300,000 people. At present, although there are no official statistics, I suspect that, out of sheer embarrassment, its population might not even reach 1,000.

Fortunately for us, the vast majority of that enormous debt is held by Chinese banks, but we in the West aren’t off the hook either, and you’ll see what I mean in a moment.

The asset bubble that has formed – of which Evergrande is the tip of a huge iceberg – has burst because these low-quality assets can find neither a buyer nor a source of refinancing, leaving the Chinese government with only two options: neither of which is particularly appealing: either let it collapse, triggering a financial domino effect like the one we saw in the West in 2008, or, conversely, bail it out – in other words, nationalise its debt.

You’ll have to admit that it sounds sarcastic that the leaders of communist countries should have to socialise the private debt of their private companies.

But let no one panic just yet. The Chinese government, through its central bank, has sufficient clout to do so. It has long held 3.2 trillion (US trillions) in foreign exchange reserves on its balance sheet, but using it for this purpose would immediately lead to a devaluation of the yuan, at a time when the shift in the growth model has drastically reduced its trade balance, from a surplus of 10 per cent to less than 1 per cent.

“A devaluation of the yuan to prop up the property market crash will impoverish the Chinese population, which is still light years away from the American one”

A devaluation of its currency will have a drastic impact on the purchasing power of its citizens, whose average per capita income is still four times lower than that of the US. And this in a country of two faces: economic freedom in exchange for citizens accepting political oppression.

As with most icebergs, we don’t yet know the full extent of this one. In this case, and for the time being at least, given how little we know, let’s hope it doesn’t sink us like the Titanic, because we’re going to witness it live and first-hand. So let’s at least put on our wetsuits; we’ll see if we need to dig the survival suit out of the cupboard.