Chinese real estate developer Evergrande had global markets on edge this week. As loyal listeners to our Weekly Market Insights might recognize, we called out the potential of China’s rapid expansion of their money supply to disrupt the market about two weeks ago (watch the replay here). Let’s dive into what caused China’s housing bubble, as well as what this could mean for the future of the global economy.
Chinese Housing: Bubble Decades in the Making
China’s real estate market leverage has been excessive for over a decade. As a result, there have been reports of substantial concrete structures being built. China has over-leveraged with more concrete units than households. Now, because China has been in a bubble for some time, they created a “three red line” policy.
Source: Media Reports, SG Cross Assets Research/Economics
With this policy, China will slow down its bubble and hope for a soft landing. Here are the metrics of the guidelines:
70% ceiling on the debt to asset ratios after excluding advanced receipts
100% cap on the net debt ratio
100% cap on short-term debt cash rate
According to a sales manager of Evergrande Wealth, “more than 80,000 people – including employees, their families, and friends as well as owners of Evergrande properties – bought WMPs that raised more than 100 billion yuan in the past five years.” They call themselves a conservative company; however, they promoted 11-13% rates of return for real estate and leveraged unconditional marketing tactics — such as giving away Gucci bags — to attract customers.
Overleverage
Source: Bloomberg
When we look at Evergrande as a whole, they have about $300 billion in total liability, and $7.4 billion of that is due over the next year. Then diving a little deeper, $850 million in interest payments is anticipated over the next year, and $150 million of that is due in the next two weeks.
Rising Risk
Many are calling this the Lehman Moment, which is referencing a contagion. We do not think China will make the same mistake; however, this does not prevent them from making new mistakes. In short, we do not believe it is a Lehman Moment, but there is a contagion. It will be felt throughout the economy. All economic activity is interconnected. For example, the risk of default and a distressed lender is moving high yield debt rates up in general. Other marginal borrows or distressed borrows are seeing their lending costs increase. It is being felt across the entire debt market. Or it is contagious. Is it enough to create a domino effect; unlikely since the PBOC will step in before this occurs.
A typical retort to the Lehman Comparison is Evergrande debt has tangible assets, not financial assets. First, real estate is both a tangible and financial asset. But the problem is not the physical aspect, but what people are willing to pay for something. Second, if real estate prices drop precipitously, it will not matter how tangible they are if they are pennies on the dollar. (As an example: here is a viral video of 15 tangible buildings being destroyed which were never completed:
The Debt Limit
Source: Goldman Sachs Global Investment Research
Another headline is the spending and debt limit bill that passed in the House on September 21st. It is currently sitting in the Senate. The bill has a suspension of the debt attached, but since it is a spending bill, the Republicans can filibuster it. They likely will play this game of chicken. The House Speaker is scheduled to deal with the infrastructure bill on the 27th. In short, there is little time, and the U.S. government could default in October if the debt limit is not extended. We expect accusations to fly, but ultimately the debt limit increase will be a separate bill that can be passed through reconciliation (Republicans cannot filibuster); however, the debt limit will not be suspended but only increased, meaning the big spending bill will be delayed. We are watching closely. We consider a default unlikely, but then the political climate is not conducive.
Keep up to date with the rising risk of Evergrande in China and more every Wednesday at 3:30 p.m. C.T. And to learn more about this week’s Weekly Market Insights, be sure to listen to our recap video on our YouTube channel and SUBSCRIBE!
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Disclosures:
Economic forecasts may not develop as predicted, and there can be no guarantee that strategies promoted will be successful. Therefore, the opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
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Securities and advisory services are offered through LPL Financial, a registered investment advisor, Member FINRA/SIPC. All investing involves risk, including possible loss of principal. No strategy assures success or protects against loss.
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