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The world potentially has a huge economic crisis on the horizon.
Its cause is China's real estate sector. You must have heard that Evergrande, one of China's largest real estate companies, has filed for Chapter 15 bankruptcy in the U.S. while figuring out the renegotiation of its $340 billion debt, which started a while ago. This is a huge amount of debt, roughly equal to 2% of China's GDP. Evergrande is one of many Chinese real estate developers in trouble. Another large property developer, Country Garden, has just warned investors of bankruptcy, with 43% of its debt coming due in the next 12 months, and it needs more cash to repay them. Even with that scale, it's difficult to understand why China's real estate sector problems can become a potential global economic crisis with a spillover impact on our portfolios. But if you dig deep, you'll see an intertwined web of problems and interdependancies across China and worldwide. This can be a big risk to individual investors even without direct investment in Chinese companies. We should first understand and then protect ourselves against it. Let's talk about that! 
I'm Hoda Mehr, founder, and CEO of Stock Card, and on this blog and its accompanying YouTube channel and Podcast show, I share detailed fundamental analyses and interesting investment stories.
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China has a big problem in its real estate sector. Real estate is one of its primary growth drivers. We all have seen images and videos of China's ambitious, large-scale real estate projects over the last few years. The country has been spending on real estate staggeringly, from big new cities to airports and residential buildings. The sector represents 30% of China's GDP and is the most significant contributor to the country's economy.
This all-important sector has been facing a few challenges in recent years. The world became aware of the problem in 2021 when real estate giant Evergrande announced defaulting on $1.2 billion of its overseas bonds and planted the seeds of fear and panic in China's consumers. Two years later, in August 2023, Evergrande filed for Chapter 15 bankruptcy, allowing them to continue to deal with their massive $340 billion in debt in China and elsewhere without worrying about roughly $40B US debt and debt holder lawsuits and actions. And the debt issue isn't limited to Evergrande. Property developer Kaisa missed a $400M bond payment. In January 2022, Shimao Group defaulted on a $101M project loan, and Yuzhou Group requested a deferral for repayment of offshore bonds worth $582M. Most recently, in August 2023, Country Garden, another prominent property developer in China, spiraled into a similar debt crisis. This company carries $35B in debt, of which $15B, or 43%, is due in the next 12 months. Aside from bad planning and aggressive borrowing by these developers, they cannot meet their debt obligations because Chinese consumers are buying and investing in properties much less than before and have started selling what they already own. Most economists attribute this behavior to the consumers' pessimistic views and fear. Why Chinese Consumers Aren't Buying New Houses
For years, as China grew, the middle class grew their wealth with the country, many in the form of investing in and purchasing real estate. Here this: Homeownership reached 90% in 2020 in China, and as much as 70% of Chinese household wealth is tied to property ownership and investments. The real estate market in China is much bigger than the middle-class buying houses to live in. It has been known as a speculative market to make fast money.
You might have heard people have prepaid for Evergrande properties, and now, they are unsure if they can ever get the properties they were promised. Apparently, the largest source of income for property developers in 2020 were deposits and presales. That year, property developers raised over $1T from these two sources alone. Now, much of that investment may go down to zero, and investors may end up with significant losses. If that's not scary to an investor, then what is? It's easy to see why fear is spiraling in the market. That fear could result in lower demand for new properties, presales, and investment, which means lower prices. And we all know this: when real estate value starts decreasing, consumers see their wealth eroding, and their confidence in the real estate sector goes down with it. As a result, fewer buyers are in the market, further dragging down the prices. Existing homeowners and property investors would also decide to sell their homes to lock in their capital gain. Selling pressure pulls prices down, creating more panic-selling in the market. According to the official data, new-home prices have slipped 2.4% from a high in August 2021, and existing homes have dropped 6%. Unofficial numbers paint a much grimmer picture. For example, local agents have reported the value of real estate properties near Alibaba's HQ has dropped 25% or more. And prime real estate in Shanghai experienced a 15% drop or more compared to their peak in 2021 (source). As the property value goes down, demand and investments drop, and real estate developers run out of ways to make money to pay their debt. How Can China's Real Estate Crisis Spills Over The Entire Economy
Of course, those debt problems and bankruptcies are real issues for those companies' investors. More importantly, they will inevitably spill over to the rest of the market. Real estate developers have billions of dollars in debt to the banking system. If they can't sell their properties or have to sell them at significantly lower prices than anticipated, and if they can't get more loans to refinance their existing debt, which is true because of a policy in China that has been put in effect to manage property developers' debt, then they will have limited liquidity to pay their debt. From there, the domino effect starts. Banks that lend money to them will have a liquidity shortage. Customers who have deposits in those banks would rush to withdraw their money, and then those banks run out of cash and cannot cover their liabilities. The domino effect continues. Only a few months ago, we saw a real example of what a bank rush can do to a bank when California-based Silicon Valley Bank ran out of cash.
We already see the evidence of fear in the market. Country Garden's bondholders have already started panicking that they may not get the expected yield, selling their bonds in fear. For example, a $1B note by Country Garden due in January now trades at 13 cents on the dollar. So far, everything we've discussed is easy to understand and quite universal. This could have happened and has already happened in many other markets. But then, the story continues…
China's Real Estate Is a Huge Problem for Local Governments
China's real estate problem is also a huge problem for local governments because of how these local governments make money. In China, lands in the cities belong to the government. Companies buy the right to build a property over the land from the government for 70 years. Land-use sales revenue and real estate taxes represented 38% of the local government's revenue in 2020. This revenue will decrease if the real estate sector slows down. Some provinces received less than 20% of their annual land-use rights revenue in 2020. The real estate sector's dismay has already created a major budget issue for local governments.
The government is responsible for investing in the local infrastructure and is a big spender and a source of employment for locals, too. Lower revenue means lower spending and lower employment across Chinese provinces. So, as we discussed, the problem isn't just that Evergrande and Country Garden are running out of cash. The problem can be as big as the middle class losing their wealth, the banking system losing liquidity, and local governments losing revenue. As you can imagine, this is a HUGE and potentially catastrophic problem for the Chinese economy. Why The World Is Worried About China's Real Estate Problems
The International Monetary Fund (IMF) forecasts less than 4% GDP growth for China in the coming years. This growth rate indicates a more than 50% drop in the country's economic growth compared to the past four decades. A 50% drop in a country representing 18% of the global GDP is a big deal. Even more importantly, according to BCA Research, China has been the source of more than 40 percent of global economic growth over the past decade, compared with 22% from the U.S. and 9% from the eurozone. And, of course, China is a major trade partner to the U.S. Japan, Germany, India, Australia, and many other countries.
Bringing it to our portfolios, about 7.6% of the S&P 500's total revenue comes from China, according to FactSet. The tech companies in the S&P500 make 16% of their revenue from China. Semiconductor companies get 27% of revenue from the country. For example, the country represents 20% to 25% of Nvidia's revenue. The world economy is a massive web of interdependencies and connections. If China is in trouble, so is the rest of the world. How Can We Protect Ourselves Against China's Real Estate Risk
First of all, before panicking and taking your money out of the market in fear of China's threat to the world economy, we must say that there is still hope, and the Chinese government may very well be able to control the situation before it becomes a crisis. These measures include cutting the interest rate, giving mortgage-related incentives, and working with property developers to manage and refinance their debt.
Where there is more risk for individual investors is to invest without considering the hidden risk that may arise from the situation in China. As they say, the blade you don't see usually cuts the deepest. For example, suppose you are pouring money into Nvidia because it is skyrocketing due to the AI demand. As discussed earlier, you must also consider that a possible economic crisis in China is a risk to your Nvidia investment. In my view, the proper response to the possible economic crisis stemming from China or any other reasons is always the same:
See you next time! Comments are closed.
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