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  • Writer's pictureTyson Jonas

Making Sense of Evergrande

Please find below our email we sent out to clients on Tuesday trying to explain the Evergrande situation.

Today’s update is going to be a little bit different to my normal writing to you. The reason for this is there is a situation brewing in China that has the potential to significant impacts to markets and the global economy moving forward. I suspect that most of you would not have heard of a Chinese builder called Evergrande but it is a business that is significant to the Chinese economy and the world. Evergrande is one China’s largest developers and property companies with more than 1,300 construction projects in more than 280 cities across the country. As you would be aware, over the past decade China has been in the middle of a housing and construction boom that has caused demand for property in cities such as Shanghai, Shenzhen and Guangzhou to drive prices to some of the most expensive in the world. At it's core Evergrande is more than just a property developer, it also has arms in wealth management, through more exotic business lines including electric vehicles, health care and even a theme park. Across these various divisions they have over 200,000 employers however is thought to be indirectly responsible for more than 3,500,000 jobs. However, the longer the boom in Chinese Real Estate has lasted the more Evergrande has borrowed more and more money in order to meet demand. It is estimated that their current debt levels are over $300 Billion USD or approximately $415 Billion Australian Dollars. According to S&P Global Ratings there are reports that Evergrande is "trying to persuade" suppliers and contractors to accept physical properties as debt repayments instead of cash in an effort to preserve what cash they currently have. Alarmingly, a supplier to Evergrande Skshu Paint reported in a filing that Evergrande paid part of its debt in uncompleted property assets instead of cash. Evergrande's woes starting in August last year when Beijing imparted strict rules upon the real estate industry with the intention of reining in debt across the sector. With its previous strategy of consistently reborrowing to fund cashflow shortages suddenly not available Evergrande has been forced into increasingly deepening the discount it has been selling its property assets for in order to cash flowing into the business. In order to explain the magnitude of this debt when Lehman Brothers collapsed and caused the Global Financial Crisis their total debts were approximately $619 Billion. Over the past fortnight we have seen Evergrande has announced that it is in immense financial difficulty and may not be able to meet its debt obligations. The concern for investors is that Evergrande has nearly $1 Billion in interest payments due this year and the market is worried that it may not be able to make payments on this on. On a broad level, the number one concern regarding Evergrande is the potential for contagion or spread across the debt markets. In general, the worry is that creditors of Evergrande (the individuals and institutions that have lent money to Evergrande) are not able to pay, this may cause these creditors themselves to not be able to meet their own obligations. Additionally, as you can imagine Real Estate and Construction contributes a huge percentage to the Chinese Economy and a significant slow down within this sector is likely to have ramifications on our local shores. As we have seen over the past decade Iron ore is one of Australia’s largest exports to China and as this issue has started to rear its head, the spot price of Iron Ore has fallen off a cliff (with the material being down 55% from its all time highs earlier in the year). With the importance of construction to the demand for Iron Ore, it is likely to be of a detriment to the local economy and as the demand for the commodity falls it is likely that the big miners profits will be hit over the short to medium term. This has already started to be factored in the share prices of some of the share prices of the larger iron ore miners. Another area of potential concern is the Australian Property market. At the current moment it is unlikely to directly affect local housing markets, there is the potential that should Chinese investors appetite for property globally was to dissipate and the Fear Of Missing Out be replaced by Fear Of Not Getting Out, there lies a risk that Chinese investors en masse will look to sell their Australian property holdings. The best way I can describe this situation for you in simple terms is a little like this:

1. A builder borrows $1,000,000 to build a house

2. The builder then assigns trades such as Carpenters and Plumbers to do the work, agreeing to pay them in full when the work is completed

3. The builder runs short of money and is not able to pay the trades when the money is due

4. The trades however were expecting to use the money from the builder to pay their suppliers, staff and their own debts.

5. By the builder not paying the trades, the trades themselves are unable to pay their suppliers, staff and debts, which in turn affects the ability of suppliers, staff and creditors to make their own payments.

At this current point in time, there appears to widespread thought that we are going to see Chinese Government intervention to stop this from escalating from a liquidity issue to an insolvency issue. I make no claim to being an expert on the policy decisions of the Chinese government however I suspect that we will see some form of invention. Ultimately, the full impact and possible implications of this one are unknown at the moment but in the end it is likely to either fizzle out into a non event (similar to the Greek Debt Crisis that had markets jittered for a time but was resolved rather uneventfully) or could escalate into something with more serious impacts such as the Asian Financial Crisis or I dread to say the Global Financial Crisis.

Keep assured that I will continue to monitor this situation and will be keeping you abreast of developments within the space


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