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Real Estate bubble in China and the bankruptcy of Evergrande

The largest real estate company in China is called Evergrande and it is on the verge of bankruptcy. It was founded in 1996 by a farmer named Hui Ka Yan who eventually became the richest man in Asia. This company is currently in charge of about 1,300 real estate projects in China over more than 280 cities. It has also expanded into the manufacture of electric cars, food products, and financial management. Evergrande is at the moment the most indebted real estate company in the world and in recent weeks it has stopped paying interests on more than 300 billion dollars it owes to its creditors due to its lack of financial liquidity. To curb the past excesses in the private sector of the economy, the Communist Party of China imposed in August 2020 "three red lines" for all companies:  1. Liability-to-asset ratio, of less than 70%. 2. Net gearing ratio of less than 100%. 3. Cash-to-short-term debt ratio of more than 1x.  These measures have cut off access to credits for many companies such as Evergrande, causing them to no longer be able to continue their operations. On the other hand, the Communist Party of China hopes that these measures will reduce the risk of a bubble bursting in any sector of the economy in the medium and long term, with the social instability that an event of this nature entails. President Xi Jinping, who has promised to fight against corruption and other 'excesses of capitalism' since the beginning of his term, made clear government's stance on high housing prices and the fact that approximately 20% of them are empty, stating that: "the houses are for living, not for speculation." Chinese cities are indeed the most expensive in the world to buy real estate taking into account the price-income ratio of the population: A Chinese citizen with an income of $ 50,000 a year typically faces prices of $ 1.2 million to buy a home. At the same time, China has one of the highest home ownership rates in the world, which is 80% compared to 35% in the United States. Moreover, 20% of Chinese families own two or more real estate properties. How has this imbalance been possible? In 1978 China initiated a series of economic liberalization reforms after the death of Communist dictator Mao Zedong. By the mid-1990s, Chinese families already had permission to own, buy, and sell real estate. The government gave citizens the ability to buy the homes in which they lived, which until then were exclusive property of the Chinese state, for a very low price. This gave suddenly many families an important initial asset. Chinese culture also promotes a philosophy of cooperation among members of the extended family, so that in most cases it is not individuals nor newly married couples who buy a property, but many people within the family get together to make this investment with the aim of having an economic profit in the future. This is possible as saving rate in China is about 50% of GDP, one of the highest in the world and much higher than in the United States, which is 15%, so it is common to have solvency to help children to buy real estate. The Chinese government, which owns most of the banks in the country, established since the global crisis of 2007-2008 that the construction sector should be the most important economic drive of its domestic market, giving a lot of advantages to families, local governments and companies to build almost 18 million units every year. The political class has bet that urbanization and wages will continue to increase rapidly. For their part, Chinese families have been confident that home prices will continue to rise during a lot of time because it is a core part of the government's economic strategy, which has always come to the rescue with interventions in the real estate market on all previous crisis. This led to a massive purchase of homes by Chinese families as a safe and highly profitable investment. Evergrande is so large that its assets represent 2% of China's economy. The real estate sector in turn represents 10% of the GDP and has many multiplier effects on the rest of the economy, so the bankruptcy of this company would cause an earthquake that will affect many financial entities and all the families who bought a home as a form of investment. At the same time, Beijing seeks precisely to send a message that these excesses are over and that those responsible have to pay the consequences of their actions.  In the end, it is possible that the government will help families in some way to not lose their homes, especially considering that Xi Jinping will seek to renew his mandate in 2022, but will not come to the rescue of real estate companies in particular. For now, the value of Evergrande shares has plummeted more than 80% since February this year, and although this company is not as interconnected with the world economy as Lehman Brothers and the rest of the US financial institutions were before the Great Recession of 2007-2008, there is a risk that an economic crisis will emerge in China and thus affect the recovery of world economic activity after the pandemic.


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