China’s Property Problems Come Home to Roost

Listen to this post

On Monday, the markets experienced a tremendous early sell-off.

We saw a big drop in the price of oil, copper, and other commodities. Cryptocurrencies plunged, with Bitcoin dropping more than 10%.

We’ve discussed a number of challenges facing the market. The Federal Reserve will talk about tapering its nearly $9 trillion balance sheet during its September meeting this week.

The Treasury Department is raising alarms around the possibility of the government defaulting on its debt unless Congress raises the debt ceiling.

And — as I’ve noted several times — equity valuations are stretched to their highest levels since the dot-com bubble.

But if you really want to understand where the Monday downturn originated, we have to look to China.

The nation is facing a potential Lehman Brothers moment with the impending failure of its second-largest property developer.

Let me explain the saga of a company called Evergrande, and the possible impact of a looming debt default.

The History of Financial Crisis

In 2009, authors Carmen Reinhart and Kenneth Rogoff wrote an extraordinary book about the history of financial crises. The book, “This Time is Different: Eight Centuries of Financial Folly,” tracks nearly every financial crisis back into the Middle Ages.

The more you read, the more you find that two unique variables are common drivers of crisis:

1. land and property speculation
2. excessive debt/leverage that facilitates the collapse of multiple banks

So, it’s fair to be nervous about the latest developments at Evergrande, China’s second-largest property developer. The company currently maintains about $300 billion in debt liabilities.

Swiss investment bank UBS says that figure represents about 6.5% of the total debt held in the entire Chinese property sector.

Unless the company can raise money, it may default on its debts this week. At its core, it is a homebuilder — bringing in about $100 billion in sales last year and $5 billion in profits.

But it started to speculate in outside ventures. In 2019, Evergrande invested a lot of dollars in the crowded electric vehicle space and claimed it could take on Tesla. In recent years, it entered the internet management and media world. In 2017, it announced plans to build 15 theme parks.

The problem is that all of its businesses are cash-intensive. The company wasn’t kicking off a lot of cash flow, as evident from its adjusted profit margins of about 5%.

So, what did it do? It borrowed lots of money.

It ran up total liabilities of $313 billion, according to UBS (that’s about 2% of China’s GDP). That figure, remember, is three times its revenue and nearly 60 times its annual profits. Simply put, the numbers stopped adding up.

When the debt load increased dramatically, so did the interest rates. Investors in the company knew that Evergrande had a large amount of debt, so they demanded higher payments for their capital.

Now the reckoning has arrived.

Money is one concern; social impact is the other. The company employs about 200,000 people and is working on about 1,300 projects in 280 cities in the world’s second-largest economy.

China has been actively trying to prevent exposure to Evergrande’s liabilities from spreading to other industries. However, Monday’s sell-off suggested that this event could have drastic impacts on investor confidence in China.

As I also noted in previous editorials, China started widespread crackdowns of its technology, education, and health care sectors in 2020. Meanwhile, it attempted to prevent a red-hot property market from overheating earlier this year.

China not only limited the amount of borrowing in the property sector in October 2020, but it also has been demolishing unfinished property projects around Central China. The government just blew up $154 million in unfinished residential towers in the Liyang Star City project in Yunnan Province. The government blew up 15 buildings in the space of just 45 seconds.

The Impact of the Struggles

When I talk about the risk of Evergrande’s potential collapse spreading, I’m talking about this event potentially hammering investors in Hong Kong or affecting other global markets and investors with exposure to certain commodities. Already, shares of China-focused banks in the United Kingdom like Standard Chartered and HSBC have taken big hits.

But it’s bigger than that. The nation of Australia could take a massive hit because of the falling prices of iron ore, which is Australia’s largest export. Chinese demand for copper and nickel is robust in the housing sector. A cooldown — or straight-up collapse — in demand could have dramatic impacts on mining companies that have enjoyed a year of higher commodity prices. These companies also borrowed money to expand operations after COVID-19 under the assumption that commodity prices would remain high.

But lower prices in iron ore could affect the credit ratings of these companies. And, at a time when China is already putting sanctions on various imports from the U.S. and Australia,  tensions between China and the West could escalate.

How large would the shockwave be? It remains to be seen, as China is continually shrouded by secrecy. Some analysts have suggested that it could be similar to the collapse of Lehman Brothers in 2008.

Others have suggested that it would rival the collapse of hedge fund Long Term Capital Management in 1998. That institution collapsed due to significant exposure to the 1997 Asian financial crisis and the 1998 Russian financial crisis.

Evergrande’s collapse couldn’t come at a worse time for China. The nation is facing extensive challenges in procuring semiconductors to keep up with demand in key sectors like manufacturing. It is also engaged in a soft Cold War over technology and the South China Sea with the West.

If it feels like we operate in a world where there’s just one financial crisis after another — it should. Debt loads around the globe continue to surge in the wake of the COVID-19 crisis. Janet Yellen is begging Congress and the White House to stop bickering and prevent a default.

Evergrande has been a predictable crisis. There appear to be many more crises popping up around the globe. This is a reminder that we want to keep our trailing stops tight.

And should we find ourselves in a very bearish situation, you’ll be among the first to know when the Bearseye signal triggers in our system.

I’ll be back tomorrow with a different way to be defensive in today’s volatile market.