In recent weeks, the global capital markets have been exposed to the real debt problem of the huge Chinese real estate corporation – Evergrand (Evergrande). The problems of leverage (financing with the help of debt) of the Chinese economy in general, and the Chinese real estate industry in particular – have been bubbling for years.
Anyone who knows even at a basic level the structure of the Chinese economy knows that China is a country of real estate investors. Investments in the Chinese real estate industry today are larger than real estate investments in the United States at the peak of 2007, and even more than real estate investments at the peak of the bubble Japanese – in the early 90s of the last century.
This is a major and very important industry in the Chinese economy. Just explain to the ear; If we summarize the real estate market for businesses and residences in China, it will dominate over a third of the modern Chinese economy. That’s a lot!
Cheap and easy loans
The Chinese economy has been characterized for years by a very permissive debt market; We would, very easy for a business or business venture to get a loan, on very favorable terms. In such a situation, it is not difficult to predict that companies and business corporations will take out more and more loans (leverage), and increase their business risk. What is the risk? As the company takes out more loans, it is forced to hand over a growing portion of its cash flow to interest payments and repay old debts. If it does not meet the interest or principal payments, it may be forced into insolvency and liquidation.
As a rule, leverage is a double-edged sword; For investors, the more leveraged the company (more external loans / more foreign capital) it will give them a higher return on their investment. The company actually utilizes the loan money and with their help creates excellent profits for investors. All this is true, as long as the profits are much higher than the financing costs of the loans. As mentioned, if the level of profitability falls, there is a fear that the cash flow will not be enough for the company to meet all its obligations – and the company will go into a spin and collapse.
The perfect level of leverage
What is the ideal level of leverage? The answer to this is not simple; And it depends on a wide range of unique characteristics of each industry, firm and business. In general, the firm’s strategic financial management includes an examination and determination of the appropriate level of leverage for the company and the period. This is a fateful decision that can differentiate between a dizzying business success and a colossal failure (ZLSH or TRASH).
The Chinese real estate market is a well-known hub of Very high leverage, In relation to what is accepted in other countries of the world. The external and especially internal debt risk of the Chinese real estate industry has been a topic that has been talked about for years.
Evergrand is a huge real estate corporation, the second largest in China. It is at the core of the real estate and investment industry in China. The company was established in 1996, and it controls over 1,300 major real estate projects in 280 different cities across China. The company’s asset management arm handles over 2,800 real estate projects, and has over 1.5 million Chinese investors who have already paid advances (cash deposits). ), Against the purchase of assets “on paper” (the construction of which has not yet been completed).
Evergrand has total liabilities of over $ 300 billion (US), and is having a hard time maintaining its debts. There is a real fear that this Chinese giant will collapse. If God forbid it collapses, very significant direct and secondary damages are expected; And foreigners, multiple sub-suppliers, foreign and domestic investors, workers, buyers, etc.
Market adhesion (Market Contagion)
Capital markets tend to move in a coordinated manner, especially in times of crisis and falling prices. We have seen this in recent weeks, when concerns about Evergrand have led to very sharp price declines in the capital markets of the East, Europe and the US.
The phenomenon is called market adhesion and is the basis for the common saying in our capital market: when in the American capital market Sneezing, The Tel Aviv Stock Exchange snatches Acute pneumonia. Hence the great fear of some investors that a rapid collapse of Evergrand will eventually lead to the outbreak of a global financial crisis.
To put it simply, investors now face a number of possible scenarios, the main ones being the very optimistic scenario, and the very pessimistic scenario.
The optimistic scenario
The impending collapse of Evergrand will lead the Chinese government to recognize that they are “too big to fall” (Too Big To Fail). The Chinese government will go into the thick of things and cash flow to Evergrand, with the aim of creating stability in the real estate industry and protecting investors. In this scenario, the Chinese economy in general, and the Chinese real estate industry in particular will see a major revival and beautiful price increases, under the auspices of the Chinese government’s deep pockets.Bulls) Will be justified and the price increases are expected to be extremely significant.
Investors who believe in this scenario, can make a speculative investment (at particularly high risk) in a Chinese mutual fund such as iShares MSCI China (MCHI) Or for more direct exposure to Chinese real estate Global X MSCI China Real Estate (CHIR). It is emphasized that this is a high-risk investment, given the waves of declines in these markets. On the other hand, sometimes you have to swim against the current in order to earn an extraordinary return …
But the optimistic scenario is only one possibility, it is possible that the bears (Bears) Are right, and the capital markets will experience a crisis – In the realization of the pessimistic scenario.
The pessimistic scenario
The Chinese authorities decide not to intervene and let the free market make the necessary correction. The reason for this is Moral risk (Moral Hazard); If we save failing companies in the present, we will encourage other companies to take unnecessary risks in the future (with the understanding that they too will have to be saved).
Therefore, Evergrand collapses into itself, leaving billions in debt and unfinished projects. Millions of Chinese investors are experiencing huge losses, more and more real estate firms, banks, subcontractors, etc. are collapsing one after the other. Life.
The tightening of the markets is leading to the rest of the world experiencing price collapses, painful declines in output and production, and deletions of investments on a formidable scale similar to the 2008 subprime crisis.
Investors who believe in the pessimistic scenario, can make a very risky investment in the foreign exchange market. For example, the Australian dollar (AUD) Is highly correlated with Chinese growth and is expected to undergo a significant devaluation in a situation of deep Chinese crisis. Against, the Japanese yen (JPY) Is known as a very defensive currency, and protects its value in complex financial periods. Note that this is a very speculative investment idea, which includes inherent financial risks both from the world of investments and from the world of highly volatile foreign exchange. you have been warned!
China is a country of real estate investors, and includes an increased component of over-leveraging (loans). In a good place in the middle; a limited intervention by the Chinese government in order to stabilize the situation.
Hillel Bash ([email protected]) – Financial risk manager at Smart Options Ltd., a lecturer at the Lev Academic Center and Bar Ilan University.
The above should not be construed as a recommendation for the performance of operations and / or investment advice and / or investment marketing and / or advice of any kind. The information presented is for information only and is not a substitute for advice that takes into account the data and the special needs of each person. Anyone who uses the above information – does so at his own discretion and sole responsibility. The company and / or the authors hold and / or may hold some of the papers mentioned above.