By: Zachary Notkin  | 

The Evergrande Effect

Ever since China joined the World Trade Organization (WTO) in 2001, the rise of trade between it and the rest of the world has been meteoric. According to the WTO, China is the largest trading partner of both the United States and the European Union. It isn't surprising that China has the largest GDP adjusted for purchasing power parity in the world. 

It is no wonder that this rise has generated a mixed response from the international community. China is an authoritarian state controlled by the Chinese Communist Party, an organization responsible for such tragedies as the Great Leap Forward, in which 15 to 55 million people died. Some worry that China will overtake the US as the world's dominant superpower, while others dismiss its growth as a flash in the pan. One thing that everyone can agree on is that China is a very different place than a western country, so understanding it can be difficult. 

It is with that backdrop that we examine the recent happenings regarding the Chinese property giant, Evergrande. Evergrande buys land and develops homes on it for people to buy. In order to pay for the land and build the homes, it must borrow money or take payment upfront. 

In recent years, Chinese property values have exploded to never before seen heights. This is primarily due to cultural reasons, as the population traditionally views land as the ultimate store of wealth. Anecdotal evidence suggests that if a Chinese man wants to get married, he must first own a home. Ever since the Chinese population became urbanized, the demand for homes in cities has skyrocketed, fuelling rampant speculation in the property market. This means that people will borrow or spend money they can’t afford to lose in order to buy homes in hope of selling them at a higher price. These ever-rising prices also prompted developers to build even when it has made little economic sense to do so. Merely searching YouTube for “Chinese Ghost Cities” can provide examples of this 

The fear that this could lead to a bubble, meaning inflated values that must eventually collapse, made Chinese regulators enact the so-called “Three Red Lines policy”, attempting to limit the amount that real estate companies could borrow, hoping to avoid a collapse similar to what happened in Japan in the 1990s. Despite this, Chinese companies have been faced with unending demand for new developments, and have been borrowing more and more to keep up. If the companies cannot borrow any further, they must either sell the homes before they are built, or they must sell assets at a discount, thereby losing money. This also might spark a collapse in property values if the discounts are too large. However, investors did not hesitate to lend to these companies.

That was until a month ago, when Chinese property giant Evergrande started making late payments on its bonds, which are held by overseas investors. The fear that the company would be unable to repay its loans and go bankrupt caused its share price to collapse and the yields on all Chinese real estate company bonds to skyrocket. Despite the fact that investors are spooked, Evergrande has been able to make late payments through the sale of assets, possibly even including through the owner's private yacht

The Chinese government, meanwhile, has said that if Evergrande collapses, it will not directly receive a bailout, but the Government will make sure that the damage to the property market does not spread. This worries those who have already paid for properties that Evergrande is supposed to build. If the government would be unable to control the collapse and the real estate bubble bursts, it would devastate everybody from the local authorities whose main source of revenue is the sale of land to developers, to the multitude of construction companies that actually build the homes, to the millions of Chinese whose primary store of wealth is their homes. The fallout from such a collapse is so large that the United States Federal Reserve has already warned of potentially harmful effects globally.

Despite these fears, Evergrande has not defaulted, even if the S&P predicts that it will. The party may be over; Cathie Woods, CEO of ArkInvest, stated in a recent interview that she believes that China will follow the pattern of Japan in the 1990s meaning it will collapse. She believes that the Chinese government is playing with fire in an attempt to lower housing prices at a sustainable rate, and it will get burnt. Part of her evidence is the suppressed prices of commodities such as iron and copper. She reasons that these lower prices are the result of lower demand from Chinese firms, meaning the economy has slowed down considerably. 

However, the global economy is an incredibly complex machine. The low demand for raw materials may be related to another issue, namely an energy crisis. If companies get less energy for their money, they will process less raw material. Unfortunately, there has been a large increase in natural gas prices in Europe and Asia over the past couple of months, as well as a severe coal shortage in China that may have ended by now. 

This underlines the complexity of the global economy and explains why trying to predict it is so difficult. Nobody can account for the multitude of variables involved. However, there is one type of statistic that can predict the future better than any other type, and that is demographics. 

Demographics is the measurement of populations, which is important to the economy because the economy is made out of people. The most recent Chinese census, released in 2020, shows the Chinese population peaking in 2027. Even if there were to be a major baby boom, those children would not enter the workforce for another twenty years. Who will buy all the homes that real estate companies are planning on selling?

Despite the complexity of predicting macroeconomic trends, the risk of a collapse in the Chinese economy seems clear. I would argue that the question is when it will happen, not if. Even if China’s central government can mitigate all the risks until the end of time, the country will become old before it becomes rich. In the end, Evergrande is a symptom, not a disease.

Picture:  Pixabay 

Picture caption: Investors wonder whether the Chinese housing market will collapse.