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Default risk of Evergrande; another Lehman event knocking or evolution at work?

As of September 1st 2021, market cap of Evergrande was $7.1Bn. On March 31, 2015 it had the market cap of $7.3 Bn, post which market cap went up substantially and touched massive $50Bn on October 31 2017. The numbers indicate extreme variation and now the numbers came down drastically. Market cap of $7Bn makes it one of the valuable companies globally. But as of today, Evergrande has enormous debt of approximately $305Bn. It is struggling to pay its supplier; and to add to the trouble, property sales expected to continue to drop. This makes Evergrande’s cash flow unattractive. Lenders of Evergrande understand the troubled cash flow and the situation that Evergrande is in. Some of the Evergrande’s lenders wouldn’t extend new loan to property buyers. Chinese regulation to put cap on debt ratios (debt : cash, debt: assets and debt : equity) in order to curb borrowings had already created problem for Evergrande. Today Evergrande presents high default risk. The question is, does the rippling effect of the fall of Evergrande has the potential of disturbing global financial market?

If Evergrande collapses it definitely has the potential to impact Chinese economy. Due to supply chain effect it would also effect some of the players that are directly or indirectly connected to Evergrande. Approximately 40% of banking system assets in China is related to property segment. Now look at some of the numbers that says that Evergrande event most probably wouldn’t impact severely global financial system.

According to UBS estimate, total liability of Chinese property sector: $4.7Tr of which offshore bond market share is just 4.5%. Evergrande liability is approximately $300Bn and which is 6.5% of total property sector liability. Another data suggests that big 4 state owned bank in China has 2%-5% of total loan exposure to Evergrande. These numbers don’t augur too well for Chinese economy and if the event occurs (fall of Evengrande) this would bring systemic risk. But from global perspective it can be safely analyzed that it won’t have that much of a severe impact.

So if Evergrande fails what would happen is Chinese economy? Not much, although it has potential but it is highly unexpected that Chinese government would allow the impact to go uncontrolled. The economy is massive and it has the capacity to sustain it. Chinese government has decided till now, not to bail out Evergrande. To me, it is a very prudent decision as this will be lessons for corporates for reckless and too much of lending. Evergrande may be asked to restructure and shed off some of the assets to reckon with some portion of the debt. Evergrande has physical assets and not financial asset, and Government has control over the economy to the larger extent- these two factors are of prime importance to ascertain that it won’t not be like Lehman. So if Evergrande is not bailed out and the impact of fall is contained it is actually good for the economy in long run. This is evolution at work. The fall of Evergrande will make the Chinese system stronger for the future. Sometimes small shock in the system is necessary to make it stronger. The bailout would make the system weak and fragile. This is an event that is defining the future nature of Chinese economy.

So far there has been a very few sign that indicates global turmoil- for example there has not been any significant variation in volatility index and U.S. LIBOR-OIS spread. Evergrande is a different issue where the damage can be contained and a strategic and deliberate move by Chinese government to allow it to fail can put a solid foundation of future Chinese economy. This is evolution at work!

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