Markets Betting Against an Evergrande 'Lehman Moment'

Growing fears that Chinese property developer China Evergrande Group (EGRNY) sits on the edge of bankruptcy sent a shockwave through global financial markets last Monday, with China's Shanghai Stock Exchange Composite Index (SSE Composite) plunging as much as 2%, the Dow Jones Industrial Average slumping 1.78%, and Bitcoin sinking 10%. Fears about the company defaulting on thousands of creditors and would-be property owners even have some investors drawing parallels to the infamous collapse of U.S. investment bank Lehman Brothers at the height of the financial crisis in 2008.

Below, we examine the factors that led to Evergrande building up an unstainable amount of debt, the likelihood of economic contagion should the property developer fail to meet its debt obligations, and how financial markets have responded to evolving developments surrounding the company.

Laying the Debt Foundation

Based in the southern Chinese city of Shenzhen, Evergrande has forged itself into a real estate empire since its 1996 founding, capitalizing on the country's burgeoning middle class and subsequent booming demand for residential housing, shopping malls, and offices. As well as claiming to own more than 1,300 projects in more than 280 cities across China, the property developer has branched into financial services, health services, electric vehicles, and even theme park ownership, riding high on 25 years of success.

Cracks Appearing

Cracks started to appear last year when Beijing introduced a host of policies to slow down the country's red-hot property market amid fears over mounting debt levels. The measures reduced Evergrande's ability to borrow, having a flow-on effect of forcing it to offload apartments at a discount to generate cash for funding new developments.

The property developer has also struggled to move apartments in China's less-populous and smaller cities, adding further liquidity issues in recent months. Evergrande last week told investors that a downturn in signed contracts had put "tremendous pressure on the group's cash flow and liquidity." It also blamed negative media reports for zapping buyer confidence.

Last Thursday, the company missed paying $83.5 million interest on one of its corporate bonds, with investors closely watching if it will meet another $47.5 million payment due on Wednesday. Interestingly, global markets have rallied in recent sessions, baking in the prospect of a bailout or corporate debt restructuring arriving more quickly if Evergrande misses further interest payments.

Contagion Effect

Throughout the boom, Evergrande has amassed liabilities of $300 billion, making it the most indebted company in the world. Therefore, it's not surprising that bankruptcy reverberations rattled global markets when the company recently said it doesn't have the means to pay its long lineup of creditors on time. Commentators have even compared an Evergrande collapse to the downfall of financial services behemoth Lehman Brothers 13 years ago that sent shockwaves through the global financial system.

There remains a great deal of uncertainty about whether the Chinese government is prepared to step in to prevent a full-blown Evergrande collapse. While the People's Bank of China (PBOC) pumped $17 billion into the country's banking system to shore up credit conditions, government officials haven't indicated they will bail out the embattled property developer. However, Beijing remains acutely aware that an Evergrande failure could hugely undermine confidence in China's $60 trillion property market, which represents around 20% of gross domestic product (GDP) and accounts for 62% of household wealth.

Markets Say No 'Lehman Moment'

Despite steep falls across financial markets early last week over contagion fears stemming from an Evergrande collapse, investors now appear to be betting that the Chinese government will restructure the troubled company. The SSE Composite is currently trading 4% above last week's low, while the S&P 500 has bounced back 2.2% from last Monday's Evergrande-induced sell-off.

Sell-side research firm Yardeni believes that the Chinese government will be aware of the potential for global repercussions if the property developer were to go under, drawing on experience from the Lehman Brothers collapse. "I think the Chinese government is very well aware of what the risks are with regards to Evergrande. I don't think they will bail it out so much restructure it," Yardeni said.

Similarly, Fidelity International sees a restructuring involving strategic investors as the most probable outcome. "If we look at the past three years, we have seen restructuring that the government or regulators have been involved in, whether it's Huarong, China Fortune Land, and other single credit events. So they have the confidence in terms of this potential restructuring," the asset manager told Bloomberg. "The likely scenario is that they will avoid bankruptcy when it comes to Evergrande [and] seek restructuring with strategic investors or bridge investors," Fidelity added.

Either way, investors will anxiously be watching for further Evergrande developments as the week unfolds.