Is China on the brink of a real estate debacle?

Twice in the past month, markets have been roiled by rumours that China’s Evergrande Group had defaulted on its debt service payments to offshore investors. In both cases, Evergrande made the payment at the last moment, avoiding default but not before triggering a precipitous fall in stock markets around the world, and causing the People’s Bank of China (PBOC) to inject some 120 billion Yuan (~$19 billion) into the financial system to prevent further contagion.

Evergrande is a giant real estate development company with $300 billion in debt. The company owns thirteen hundred developments in nearly three hundred cities, and it now teeters on the brink of bankruptcy and is relying on the Chinese Government to keep it afloat. This puts the Chinese Government in a difficult position as it does not wish to set a precedent by bailing out a major private sector company in an unpopular industry, particularly when there are numerous other developers in similar straits. The government also does not wish to be perceived as enabling a real estate bubble that is hurting many in the population.

In general, real estate developers are not well liked by the Chinese population since, as the chart above shows, housing prices have outstripped inflation by a significant margin over the past fifteen years and more significantly since 2017. Thus, in a country where most people own their houses, young people now believe they will never be able to afford one of their own and any action to pop the bubble in housing prices would deal a financial blow to the net worth of many ordinary Chinese citizens.

In addition to the cost of housing, the process whereby prospective Chinese homeowners are frequently required to pay for their homes before the developer even starts building, has led to widespread dissatisfaction, when homes that are paid for are never delivered. In this regard, Evergrande, as at the end of June, had committed to building 1.4 million new homes.

The Chinese government must also consider that a vibrant real estate market is critical to the finances of regional governments. A large portion of provincial revenues is generated from transfer taxes. A collapse in building activity could hamper local governments.

Markets are left to ponder whether the Chinese Government will be forced to bail out Evergrande, or whether it will allow the company to default on foreign creditors while protecting domestic lenders. It is generally assumed the government will strive to protect prospective homeowners who have already paid for their homes.

It is virtually impossible to predict the outcome of this situation. Financial markets currently believe that the Chinese government will manage the situation. However, we shall have to be vigilant to ensure that we do not get blindsided by a sudden shock in global capital markets that the Chinese Government does not control.

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