China's Evergrande Crisis Is Just The Tip Of The Iceberg
Sep. 20, 2021 3:41 PM ETChina Evergrande Group (EGRNF)ASHR, CHIX, CICHF...162 Comments 144 Likes
Summary
- Financial assets crashed worldwide on Monday as the second-largest property developer Evergrande collapsed.
- China has been in a property bubble for years, with home price-to-income ratios over 30X and the development of numerous vacant cities around the country.
- The PBOC already has cut bank reserve ratios many times to avoid a systemic collapse of its property bubble and has limited liquidity creation avenues left.
- Evergrande's collapse has spread to another developer, Sinic Holdings, and others may follow suit due to massive debt levels across China's real estate industry.
- The unwinding of China's property bubble may catalyze a crash in the U.S. equity market due to numerous risks facing the U.S. financial system.
Tip of the iceberg.
Björn Forenius/iStock via Getty Images
Global financial markets suffered a tumultuous day on Monday as the Chinese Evergrande crisis made mainstream headlines. While Evergrande has been collapsing for weeks, the firm is nearing key default dates, which may spur a more significant liquidity crisis. Indeed, given the immense increase in the interdependence between China, the U.S, and other nations, it seems possible this crisis could have a domino effect across the world.
I have been keeping a close eye on the Chinese property market for some time. In 2018, I wrote "The $42 Trillion Bubble," which covered the immense property bubble in China. The value of all Chinese real estate has since climbed to some level above $52 trillion. For years, the question has not been whether or not the Chinese property market is in a bubble (as it is pretty obvious looking at all statistics), but when it will burst. While most Chinese equities have declined in value since 2018, the country's property bubble has only continued to mount as the PBOC has continued to push liquidity into the country to stave off a major unwind. Most importantly, how China's leadership will react to such an unwind and whether or not its effects will spread to the United States. All of these critical questions may be answered over the coming weeks.
How Large The Evergrande Crisis Truly Is
Evergrande Group (OTCPK:EGRNF) was, up until recently, China's second-largest property developer with total debt above $300 billion. The company's crisis began as the Chinese government tightened leverage restrictions on its exuberant property market. The second causal factor has been an immense increase in construction material costs due to global inflation and supply shortages. Chinese property developers have thin profit margins and use tremendous debt, so any surprise increases to supply prices make it nearly impossible for them to break even.
Evergrande lacks the liquidity to pay suppliers, contractors, and debt investors and is attempting to offer physical assets instead of cash. However, retail investors in China, which have not experienced a financial shock of this magnitude in decades, remain upset and held Evergrande management employees hostage in their offices earlier this week. This led to a crash in the company's credit risk tolerance, causing a slew of legal cases from companies and individuals purchasing assets developed by the company.
Thus far, the property crisis in China is playing out quite similar to that of the U.S around 2007-2008. Real estate has been the go-to investment for retail investors in China for decades. Chinese investors put very little wealth into equities and nearly 70% in real estate. There's a cultural basis for this as it's a historical custom that men in China should own a home before they are married, hence the country boasts an impressive 90% homeownership rate. However, this has caused immense increases to property valuations in China which carry an estimated average price-to-income ratio of 27X (27 years of household income). This can be compared to the U.S, which, despite having peak home prices, has a property market with an average price-to-income ratio of ~4X. In major cities like Shenzhen and Hong Kong, this figure is above 46X, and rental yields are below 2%, giving those properties negative-carry costs after mortgage rates and taxes.
Real estate is a big business in China as most individual wealth is wrapped up in the property market, with many owning more than one apartment. Chinese people save nearly 40% of their annual income to invest in these costly properties (Americans generally save less than 8%). This exuberance has led to the development of countless nearly empty "ghost cities" and a startling vacancy rate of around 22% (vacancies are typically around 5% in the rest of the world). However, whenever property prices have declined, the People Bank of China has been quick to lower bank reserve requirements to boost liquidity. See below:
(Trading Economics)
The truth is that Chinese properties were technically overvalued a decade ago. However, most of the country's wealth depends on the property market, so the government has been quick to relax bank lending requirements to allow developers and homebuyers more capital. To many investors, this has made it seem that the country's property market is "rock solid" and "will never crash," but this capital leniency also has created tremendous debt growth of over 300% of China's GDP.
While it's virtually guaranteed that China's leadership will take all possible actions to ward off a massive potential liquidity crisis, the Wizard of Oz is merely human. The fact is that all possible actions only exacerbate an already giant bubble. At this point, it seems unlikely that the PBOC will allow the country's bank reserve ratio requirement to decline too much further. The government has injected ~$14B via reserve-repo agreements into its financial system, but far more will likely be needed to stop a hundred-billion+ debt risk. The entire debt risk is so considerable that the country may experience hyperinflation if the PBOC becomes too dovish.
At this point, I believe the Chinese government can do very little besides calling a spade a spade. The PBOC already has lowered reserve requirements to low levels to stave off the crisis in the past. There's also nothing large enough that the Chinese government can do to limit the physical shortage of commodities, leading to higher costs for developers and consumers alike. The genie is already out of the bottle as Chinese retail property investors are finally becoming aware of the immense and immediate risks facing their wealth. As protests grow, the Chinese government is likely to become more concerned about limiting civil unrest than trying to continue to stop the inevitable popping of its property bubble.