What is Going on with Evergrande?
- James Martin 'student'
- Nov 29, 2021
- 3 min read
By: JT Martin
If you have been following financial markets over the last few months, you probably have heard the name Evergrande quite a few times. In October, the stock and bond markets watched the giant real estate development company, China Evergrande Group, extremely close as they continued to face massive debt obligations without making their payments. Professionals began to worry about default and the implications that such an enormous default would have on China and the global economy. With the equivalent of around $300 billion in debt, the default of the Chinese giant could cause massive ripple effects in global markets.
Before you decide that the global economy is failing and that China’s economy will default, let’s look deeper into the issues that Evergrande is facing. One of the primary risks associated with Evergrande is its liquidity risk. Liquidity risk refers to how quickly and accurately an asset can be converted in the market. Conceptually, this really means how fast an asset can be sold for its actual market value, with the more liquid the asset being converted faster and closer to its market value. The risk that firms carry with liquidity is that if they hold too much short-term debt when compared to their liquid assets that they can not pay off their debt obligations or has to sell off assets at a discount or “fire sale” price which puts financial strain on the firm. Investors typically look at certain ratios to examine a firm’s risk such their current ratio which compares a firm’s amount of current assets to current liabilities. The idea of liquidity risk was not measured and taken into account as much as it should have been until the financial crisis of 2008 brought to light the true impact liquidity risk can have on the global economy.
The situation in China with Evergrande was initially compared to what occurred in 2008 and Lehman Brothers. Many see the issues with Evergrande as signaling a burst in a Chinese real estate bubble similar to what caused the 2008 crisis. China’s rapid development has led to extreme growth in their real estate sector and is undoubtedly intertwined with the strength of their economy. With vasts amount of outstanding debt and huge interest payments due, Evergande was forced to halt development projects and sell off properties at huge discounts to generate cash to pay off its obligations. This creates a cycle of the company selling of projects before completion to generate cash to pay off loans while not having enough cash to complete projects and therefore not generate enough profits to pay off loans. The new regulations from the Chinese government also played a role in the Evergrande case, as they began to limit the amount of debt real estate companies could take on, and Evergrande was faced with its enormous amount of debt that it had to reduce without adequate assets to cover them efficiently. General fear over a new global crisis has subsided as Evergrande has continued to complete its interest payments, although typically at the last possible minute and through the liquidation of any assets necessary, even the firm’s private airplanes.
Investors have continued to watch the Chinese real estate market very carefully as it continues to struggle, and investors are scrutinizing other property developers to determine the amount of their liquidity risk. The possibility of default leads to major effects in investor sentiments and a herd mentality that there is high risk associated with a single company can make it even harder for them to liquidate their assets effectively as they have to convert them with speed and at appropriate prices as well as overcome investor concerns associated with the firm. This investor fear paired with the the globalization the entire economy can allow for a single company to affect the entire world’s markets, and in the case of Evergrande, the ripple effect would be massive across the globe due to not only the size of itself as a company, but also the fact that it will have large effects on the world’s second largest economy in China which will affect their financial system and international trade relations.
Evergrande’s liquidity problems seem to not have been as much of a concern as initial fears had once thought. It has been months since Evergrande was making headlines for their potential default and the Chinese real estate bubble, but Evergrande still hasnt defaulted and the Chinese property market is still viewed as relatively stable in the long-run despite some continued losses as the market learns from Evergrande and adapts accordingly. While it may now seem like investors and the market overreacted initially when the Evergrande story broke, I hope this explanation of the major implications of default and liquidity risk illustrates why Evergrande’s liquidity issues were followed so intensely by the news over the past few months.
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