Does Evergrande’s Collapse Threaten China’s Economy?

How did Evergrande reach the point of collapse?

Evergrande Group was established as a private real estate developer in 1996 at a time when China was urbanizing rapidly and the government was dismantling its system of state-provided housing by privatizing urban housing. Its core business has been property development, but it has also diversified into other industries such as electric vehicles, finance, health care, and tourism. Evergrande made its debut as a Fortune Global 500 company in 2016, just two decades after its establishment, and managed to stay on the list until 2022. It was ranked the world’s most valuable real estate brand in 2018, but was downgraded to “restricted default” by the U.S. credit rating agency Fitch in December 2021 after missing two dollar-denominated bond interest payments. In August 2023, Evergrande filed for Chapter 15 bankruptcy protection in the U.S. bankruptcy court in the Southern District of New York, a necessary step in its attempt to restructure its foreign-held debt.

Evergrande’s rapid rise was enabled by its aggressive borrowing and unconventional fundraising. Its aggressive use of leverage made it the world’s most indebted real estate developer. In 2022, its total liabilities exceeded $335 billion,* more than ten times its total revenue and about 1.8 percent of Chinese gross domestic product (GDP) that year. Of its debt, $25.4 billion was owed to foreign creditors.

Evergrande’s debt-fueled expansion soon became unsustainable. Chinese regulators attempted to curb excess borrowing in the real estate sector starting in August 2020 by capping property developers’ debt-to-cash, debt-to-assets, and debt-to-equity ratios via a set of restrictive guidelines dubbed as the “three red lines” [link in Chinese]. These restrictions backfired and tipped the property industry into crisis by aggravating market stress and impairing developers’ balance sheets. Evergrande recorded a combined net loss of $81 billion for 2021 and 2022.

What has driven China’s property boom? 

Home prices surged across China between the early 2000s and mid-2010s, with “first-tier” cities such as Beijing, Guangzhou, Shanghai, and Shenzhen leading the price rise. Between 2003 and 2014, Chinese housing prices rose by more than 10 percent per year adjusted for inflation; China's housing appreciation has been far larger even than the U.S. housing bubble.

This boom resulted from two major housing reforms over the past four decades that transformed China’s socialistic housing towards privatization and marketization. The 1988 [PDF] urban housing reform encouraged households living in employer-provided rental public housing to buy their homes at prices below market value. In 1998, additional reforms led to market-based housing and ended the old system of linking housing allocation with employment.

While housing privatization and marketization contributed to a rapid increase in homeownership and led to a significant boost in both housing and non-housing consumption, its unintended consequences have been have been a sustained spike in housing costs, land prices, and vacancy rates. 

Additionally, the Chinese government’s prolonged financial repression policies, such as persistently low real deposit rates and capital controls, have resulted in limited alternative investment options for households, fueling speculative investment in the housing market.

Could Evergrande’s bankruptcy have broader contagion effects or signal a sustained threat to China’s growth?

Evergrande’s bankruptcy is not China’s Lehman moment; its downfall is unlikely to immediately trigger a contagion across the entirety of China’s financial system. The 2008 collapse of the U.S. investment bank Lehman Brothers, at the time the largest corporate failure in U.S. history, sent the U.S. financial system spiraling. The firm failed because of its aggressive lending, facilitated by the overuse of novel, risky, and opaque financial engineering products and excess risk-taking without sufficient risk management. Unlike Lehman, Evergrande’s insolvency is due to its excessive borrowing and aggressive use of leverage, not over-securitization. Additionally, Evergrande’s loans were only 0.2 percent [link in Chinese] of total financial institution lending, and its corporate bonds were only 0.04 percent of China’s domestic bond market.

However, Evergrande’s creditors also include Chinese homebuyers and firms along the supply chain of property development, such as construction companies, appliance makers, and home decoration firms. Evergrande’s bankruptcy exacerbates the problem of weak investor and consumer confidence in the Chinese economy. It brings another negative confidence shock to Chinese households and is likely to put more potential homebuyers on the fence about buying. Restoring confidence takes time. Meanwhile, low confidence weakens housing market demand growth, dragging down the broader property sector, which constitutes nearly 30 percent of the Chinese economy.

A troubled property market also bodes ill for local governments and households because it would result in higher leverage and curtail consumption, making it more challenging to expand domestic aggregate demand.

In short, Evergrande’s downfall is unlikely to spark a contagious wave and lead to massive bank failures. However, its negative shock on the property sector—and on the Chinese economy—as well as its damage to Evergrande’s corporate creditors adds to the obstacles facing China’s economic rebound.

How could it change the view of China among global investors?

China’s central bank and financial regulators have walked back some restrictions on the property sector, encouraged banks to provide reasonable liquidity support to property developers, and expressed willingness [link in Chinese] to work with local governments to solve their hidden debt problem. However, Beijing’s lack of willingness to support households amid its anti-espionage campaigns and tenuous relationship with the West increases policy uncertainty and risk premium in China. While Beijing has been attempting to encourage foreign direct investment (FDI), such as the twenty-four specific reform measures [link in Chinese], new FDI into China in 2023 fell [link in Chinese] for the first time in more than a decade. Even without the fall of Evergrande, global investors need to be aware that structural problems within the Chinese economy remain unresolved and are beyond an easy fix by China’s fiscal and monetary policies.

If foreign bondholders are not paid back in the course of the forced liquidation, it would be another blow to investor confidence in the Chinese economy, which is already low and struggles to recover amid rising regulatory uncertainties in China and growing geopolitical tensions. 

China’s economic slowdown, especially in its property market, could dampen commodities prices by reducing demand for commodities including oil and steel, which would ease inflation pressure on the global economy. However, weak domestic demand increases the likelihood of China exporting its excess supplies, such as electric vehicles, to global markets, which could increase the risk of trade tensions between China and the United States and its allies.

*RMB2.4 trillion