China, the world's second-largest global economy, is on shaky ground in terms of its financial and real estate markets. News over the inevitable default of the country's second-largest developer, China Evergrande Group (EGRN.F 38.89%) caused market volatility in early November 2021. But the company, against all expectations, managed to come up with the money to pay the bonds due, buying some time and a little confidence for the outcome of the country's future.
Evergrande, which barely avoided default earlier this summer, is having what many are dubbing a "Lehman Brothers moment," being pinpointed as the potential pivot point for the Chinese real estate and financial markets. In other words, the straw that broke the camel's back. The country's current predicament is leaving investors wondering how it could impact the U.S. markets.
Why Evergrande's default would matter
Evergrande is a massive operator in the real estate industry across China. The company owns over 1,300 real estate projects across 280 cities across China, employing roughly 200,000 people and creating more than 3.8 million jobs each year. If the company defaults, it could be the start of a collapse, similar to what we saw in the United States during the great financial collapse, causing other entities and developers to follow suit. But the potential issues run a lot deeper than a developer's default.
Image source: Getty Images.
Overleveraged
Since 2013, China has used a unique system of local government financing vehicles (LGFVs) to help stimulate economic growth through infrastructure improvements. China doesn't reveal much about its financial vulnerability, but estimates from Goldman Sachs show outstanding debts for LGFVs could be well over $8 trillion today and make up around 52% of the country's GDP. Many of these LGFVs are considered risky and "weak," meaning in the event of collapse, far more than Evergrande's indebtedness could be at risk.
In the Federal Reserve's latest Financial Stability Report, the Reserve noted that China's financial instability could spill over into the U.S. markets because of the size, scale, and connectedness with trade and financial markets between China and the world. Instability and defaults from important operators within the country could change the appetite for investor participation, putting international trade and financial activity, including the collection of China's debts, in a vulnerable position. Japan has already stated it won't include Yuan-denominated investments in its $1.75 trillion government pension investments.
China isn't oblivious to this risk
The government recently made changes to policies to reduce further risk of default for Evergrande, a sign it's taking its debt crisis seriously. Particularly, it enacted a policy that eases barriers for Evergrande to sell its assets to repay debts, which will help Evergrande maintain future debt payments. It also has limited infrastructure developments and the ability for LGFVs to take on more debt to try to curb its mounting debt crisis. But these policies may not be enough to stop the tower from tumbling.
Right now, U.S. investors likely won't see a direct impact aside from minor market volatility, unless they are heavily invested in the Chinese market, including Chinese ETFs, or U.S. companies that own assets or investments within China. A recession, however, would likely be felt on a greater scale. Recessions are bad for any economy, particularly so for one of China's size and influence across global markets. Less employment, a common outcome during a recession, could lead to less productivity and exports, something the world has come to rely on.
