China: Eyeing the Potential Market Impact of Evergrande | Lord Abbett
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Economic Insights

Difficulties at the troubled property developer have raised market concerns about the potential effect on China’s growth

Read time: 1 minute

Concerns that the debt crisis at developer China Evergrande Group could spread to other entities in China’s sprawling property sector and potentially hinder that nation’s growth sparked market volatility on September 20.  Since China is the second largest economy in the world and the primary driver of global economic growth, the prospect of a financial crisis carries immediate negative implications for global asset prices.

News that Evergrande – one of the largest Chinese property developers – is experiencing increasing difficulty servicing its debt puts pressure on domestic financial regulators to limit contagion to domestic asset prices and avoid stress that could radiate outside of China. If Evergrande were forced to dump assets to service its debt or holders of its wealth management products were to demand accelerated repayment, it would threaten a liquidity crisis as land and unfinished property developments are the major asset held by developers and serve as collateral for loans for a broad cross section of borrowers in China.

Resolving defaults without provoking financial panics is something that Chinese regulators have a lot of practice at doing. But Evergrande is very large and a goal of financial reform in China is to encourage market pricing of assets, which involves incorporating a premium for default risk that is determined by investors who do not automatically expect comprehensive bailouts. Thus, a resolution strategy that allocates losses in a way that triggers a sudden drop in asset prices and unleashes contagion leading to a self-fulfilling negative spiral cannot be ruled out.

Prior to the market volatility of September 20, investors have largely believed that the Evergrande mess will be resolved without provoking a financial crisis that leads to an economic meltdown. The conservative approach taken by Chinese regulators to previous defaults supports that assessment and the probability that they will not make a mistake this time around is high. But, of course, there’s a first time for everything, and global investors will be keeping a keen eye on China’s ability to successfully navigate the Evergrande crisis.

 

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