last week I learned that writing posts on very technical and overly scientific topics takes way too long.
As a distraction, I dug deep into the rabbit hole called “Evergrande”, the Chinese real estate company that used to be #122 on the Forbes 500 list and that is now short $300+ billion. That seemed like a much more interesting topic to write about.
I am also experimenting with less technical explaining and more personal opinion and crystal ball gazing. Please let me know if that’s more your thing. Now on with the show.
Let’s talk about…
💰 Leveraging and Deleveraging
“Leverage” is the word you use for debt when you want to sound educated. “Deleveraging” simply means getting rid of debt, but in a fancy sounding way.
It’s one of the most important and certainly the most impactful concepts you need to know if you want to understand how our reality works.
🔍 What is it?
“Leverage refers to the use of debt (borrowed funds) to amplify returns from an investment or project.” Source: Investopedia entry for Leverage
We all have some sort of understanding how debt works. You borrow money for a fee and a promise to pay it back, and then you can use that money as a financial force multiplier in your project.
Debt as a force multiplier works great when everything goes according to plan. However, when things don’t work out as planned, the debt can work as a negative force multiplier, increasing your financial losses.
“Deleveraging is when a company or individual attempts to decrease its total financial leverage.” Source: Investopedia entry for Deleverage
OK, that was easy, right?
🤔 What are examples?
The Cororate Finance Institute has a simple example for you to better understand: “Example 1
Bob and Jim are both looking to purchase the same house that costs $500,000. Bob plans to make a 10% down payment and take a $450,000 mortgage for the rest of the payment (mortgage cost is 5% annually). Jim wants to purchase the house for $500,000 cash today. Who will realize a higher return on investment if they sell the house for $550,000 a year from today? Financial Leverage - Example 1
Although Jim makes a higher profit, Bob sees a much higher return on investment because he made $27,500 profit with an investment of only $50,000 (while Jim made $50,000 profit with a $500,000 investment).
Using the same example above, Bob and Jim realize they can only sell the house for $400,000 after a year. Who will see a greater loss on their investment? Financial Leverage - Example 2
Now that the value of the house decreased, Bob will see a much higher percentage loss on his investment (-245%), and a higher absolute dollar amount loss because of the cost of financing. In this instance, leverage has resulted in an increased loss.”
Still with me?
This is simple math, but I bet when you read about 55% profit for Bob you definitely would not have expected a -245% loss for Bob in the loss example. Or did you?
Humans simply have a hard time when numbers / maths behave this way.
💎 Why does it matter?
Leverage/debt is the capitalists best friend when everything goes according to plan. When it does not, it’s the downfall and the end of times is near.
This is exactly what we are seeing slowly unfolding in China these days.
Evergrande took on debt to invest in building, developing and selling real estate. Nothing wrong with that.
Where they went wrong, however, is that they did not use the funds collected from the real estate sales to pay back the debt (i.e., deleveraging), but used the proceeds to fund ever more real estate projects.
With more equity available to the company, they were able to take on even more debt. They now could show more assets (e.g. unfinished but not yet fully sold real estate properties) and more equity (i.e. proceeds from sales) and that made the company look even better to banks. Here, take on some more leverage. Money is cheap.
By not deleveraging properly when they should have, Evergrande turned their business into a Ponzi scheme. It all worked well because more and more Chinese went into real estate, and prices only went up during the last decades.
Real estate prices in the larger cities in China went up by a staggering 10%+ on average per year over the last decade. No surprise that many Chinese bought into this, specially since alternatives for personal finance (such as investing on the stock market) are still very underdeveloped in China.
Well, and then Corona happened. Source: National Bureau of Statistics of China, April 19, 2021
Look at that peak! Corona stimulus in full effect.
Then things changed.
Lots of small things (aging population, slowing productivity, increasing inequality, etc.) came together and changed behavior, on a massive scale.
It started late last year and developed into a noticeable trend in 2021: lots of Chinese do not want to buy real estate anymore.
A Financial Times article from Sep 21, 2021 pointed to: “…data showing the number of new home sales falling 24 per cent year on year in August across 30 cities and land sales collapsing 53 per cent in volume terms across 100 cities.”
Now we are getting to the territory of the second example from up top. Suddenly not all is well anymore.
What we are hearing on the news now, that not only Evergrande has issues deleveraging but also other real estate developers as well. This is not about a single company, this is about the entire real estate sector in China!
And, people, real estate in China is a much, much bigger deal than you can even imagine.
While real estate in the EU or US is a large part of the economy, it’s not the biggest and certainly not the most critical. Well, in China it pretty much is.
This chart shows the impact of real estate-related activities on GDP (percent) by country: Note: This figure presents the impact of real estate related activities on total GDP in China, U.S., U.K., Germany, France, Spain, Netherlands, Finland, Ireland, Japan, and Korea. Source: Rogoff and Yang (2021), via VOX article from Sep 21, 2021
And this is old data, ending in 2017. I would expect this trend to have massively persevered over the last years.
There is now an entire industry sector that is overleveraged (i.e., in too much debt), and they can not deleverage fast enough. This is a major problem.
The last time we saw a similar (but still very different) overindebtedness of an entire sector (2008 in the US) this ended pretty badly.
Weird that we are not seeing this on the news every night. Why is that?
Is it maybe because the sheer numbers and complexity of the problem is mind boggling?
🔮 What will happen?
The Chinese government is now between a rock and a hard place: no matter what they do, it will probably suck.
Just a few options to consider:
Save Evergrande? -> Expensive & bad signaling. Don't save Evergrande? -> Millions of people will loose money -> bad for social cohesion. Save the entire sector? -> How?? "Let the market fix itself" -> Too risky. At 30% GDP relevance, a crash could pull down the entire country.
What I am reading so far is that they are trying to deleverage as fast as possible. Have Evergrande sell assets asap, and have government-affiliated companies pick up the slack.
Will it end well? I doubt it.
Remember how the profit in the example further went up by 55% but the losses of the leveraged house was -245%? This is what I am afraid of, that people do not realize just how brittle the situation is.
According to e.g. data from Yahoo, Evergrande had a debt-to-equity ratio of roughly 3 in July 2021, which means that they had 3x the amount of debt than equity. Did that number go up since July 2021? You bet.
And this is only Evergrande, there are lots more companies like this in China.
I doubt that the affected masses even grasp what a gigantic risk is on their/our door step.
What I am unsure about is this:
Is this the tip of the iceberg, and we have another year or two before the sky is falling? (i.e., it's 2007 all over again?). Or will we have a very harsh winter with China and subsequent stock markets crashing around the world before Christmas?
My money, as I write this, is on the Chinese getting their act together, with drastic measures and certainly some very noticeable wave-making.
Xi Jinping wants to be “re-elected” next year, if he can not fix this mess he can kiss his grand plans for China (and his legacy) good bye.
Watch out for some really crazy diversions and news stories about more missing Chinese billionaires in the next weeks and months.
By the way, October and May have the best weather in the Taiwan straight. Perfect for a nice little invasion to divert the world from trouble at home.
All this because they exaggerated the leverage a bit.
Wikipedia entry for Evergrande Full of interesting trivia (e.g. the headquarter is on the Cayman Islands) Investopedia entry for leverage & Investopedia entry for Deleverage Good start to learn more. Investopedia is a great niche site with tons of explainer articles for all sorts of finance topics. Leverage - Guide, Examples, Formulas Corporate Finance Institute website, more technical and formal than Investopedia. Can China’s outsized real estate sector amplify a Delta-induced slowdown? Very readable article from a leading expert / professor on the topic. Nice charts. Has China’s Housing Production Peaked? 40+ pages long research paper from Harvard professor Kenneth Rogoff (who also wrote the Vox article linked above). Very detailed and somewhat dry academic literature and with no real good news. Read only if you have the time. National Real Estate Development and Sales in the First Three Months of 2021, April 19, 2021 Data from the National Bureau of Statistics of China, very detailed. The Evergrande crisis: 4 questions that explain why China's property market, which is twice as big as America's and where 20% of homes are empty, matters, October 1, 2021 Business Insider article. A bit click-baity, but good summary what is going on. How the economic machine works Brilliant 30min video by hedge fund billionaire Ray Dalio. Explains everything you need to understand markets. Includes idiot-proof explanations for all major concepts. Watch this!