China’s financial and real estate markets have been on shaky grounds lately, with the Evergrande crisis grabbing the headlines over the past few months.
With some describing Evergrande’s trouble as the straw that broke the camel’s back, China’s housing market now looks like a huge bubble that's starting to burst.
As the fate of China Evergrande Group remains unclear and with the economic recovery still threatened by global issues such as rising inflation and a chaotic supply chain, the collapse of the indebted company and the Chinese housing market at large, could have a disastrous impact on the economy.
What impact exactly? And how could this affect the price of physical gold? Let’s unpack.
China housing bubble explained
To help you better understand what is exactly going on in China, let’s refresh on the practical definition of a housing bubble:
- Housing bubbles usually start when demand is high and supply is limited, with speculators pouring money into the market, further driving up demand.
- At some point, the demand spike starts to fall, while supply continues to rise. When that happens, the bubble bursts.
And that’s exactly what’s been happening in China.
For many years, the bubble in the country’s real estate market has led to rising property prices, while construction companies scrambled to build more houses.
But lately, the demand for new housing has shrunk significantly, with home prices starting to fall for the first time in 6 years.
This has happened for a number of reasons, among which China’s aging population or simply because buying a house became too expensive.
Why is real estate so important in China?
To easily understand the extent of real estate construction in China, we could just say this:
Between 2011 and 2013, China consumed 6.6 gigatons of concrete… which is more than the U.S. used in the entire 20th century.
This gigantic amount could in part be explained by the fact that real estate was once deemed a safe and profitable investment in China.
For decades, the Chinese government has encouraged people to invest in the real estate market because it has been one of the key ways to increase the country’s wealth and household income. Why?
- Because in Communist China the land belongs to the state, and the government earns billions of dollars from land sales as well as from the earnings of the real estate market.
- Because the Chinese have a strong cultural attitude towards owning their own house. For example, in China, only around 7% of the population own stocks, while around 90% are homeowners.
So, to sum up, the incredible public interest in real estate has created a steady stream of wealth for the state while also adding to the rising number of homeowners in China.
Sounds great for China, right?
Well, the issue is that they might have overdone it a little.
Indeed, this interest in real estate has also led to the emergence of entire ghost cities, with eerie shopping malls and completed apartment blocks but almost no signs of life.
Why do ghost cities exist?
Supposedly, China currently has at least 65 million empty homes — enough to house the entire population of France.
The “ghost cities” phenomenon is not new in itself. In some parts of the U.S. and Japan, one can find abandoned homes or villages in various states of decay, but China’s ghost towns are different.
These Chinese ghost cities were not abandoned, but rather never occupied, to begin with, and are a strange symptom of the supply and demand imbalance.
"These homes being empty means they are sold out to investors and buyers, but not occupied by either the owners or renter," explained Xin Sun, a senior lecturer in Chinese and East Asian business at King's College London.
Adding that part of the problem is that “China overestimated its urbanization rate — how many people would want to move from rural to urban areas."
Want to see what a ghost city looks like? Here are some of the most famous ghost cities of China:
Tianducheng, the Paris of China
Located about two hours west of Shanghai, Tianducheng was supposed to look like a miniature Paris. Built for a population of 10,000, the town has a 300-foot (91 m) tall Eiffel tower, cobblestoned streets, Renaissance fountains, and grey Parisian facades.
According to original plans, the city was supposed to have10’000 residents. But today the town’s population is only around 10% of that. Therefore it’s unsurprising that the almost empty town is now used for the occasional exotic wedding photoshoot.
Ordos, a “doomed metropolis”
Located in the Inner Mongolian region, Ordos was initially built to house around 300,000 residents. But for many years, only around 2,000 people have lived here, with much of the city giving off the vibes of a post-apocalyptic world.
This ghost city has also been featured in the famous photo series "Unborn Cities" and "Ordos - A Failed Utopia.”
So, what exactly are the reasons why so many buildings, neighborhoods, and even cities in China have stayed vacant for years? Here are a few:
First, with investing being somewhat difficult in China, people started using real estate as an investment rather than a property to live in, buying houses and apartments only to resell them directly.
Second, because housing prices had been going up for a long time, it was relatively easy to buy and resell a property for profit, without even ever setting foot into it. As a result, real estate companies started constructing residential buildings, and even entire towns, only for this purpose, sometimes without bothering to finish the units before selling them.
And, with real estate demand running high and prices going up, real estate companies had more incentive to make profit and borrow more money to build new empty housing units. An efficient strategy, until prices stop going up and demand drops, drying up the profits and leaving highly indebted real estate companies in the dust.
What do we have at the end? People stuck with unused properties that they are unable to sell for profit, and indebted real estate companies (like Evergrande) with gigantic construction projects that are often technically worthless.
This is actually one of the main reasons behind the ongoing China Evergrande crisis that risks unravelling the global real estate market.
What is the China Evergrande crisis?
Many see the Evergrande debt crisis as a major test for Beijing, one that could send shockwaves across the world's second biggest economy and further.
And while the world is still waiting to see what will happen to Evergrande and its enormous pile of debt, let’s see what the situation is all about.
What is Evergrande?
Evergrande is one of China's biggest real estate developers and is part of the Global 500, which means that it's also one of the world's largest businesses by revenue.
Evergrande says it "owns more than 1,300 projects in more than 280 cities" across China — but its interests extend far beyond real estate.
Outside housing, China Evergrande Group has invested in electric vehicles, sports, and even theme parks. It also owns a food and beverage business, selling groceries, dairy products, and other goods in China.
How did Evergrande run into trouble?
The group is infamous for becoming China's most indebted developer, raking in more than $300 billion worth of debt.
Over the past few weeks, Evergrande has been struggling with cash flow issues, raising very real risks of default if the company remains unable to raise money quickly.
How did it come to this?
- Aggressive ambitions: the group "strayed far from its core business, which is part of how it got into this mess," said Mattie Bekink, China director of the Economist Intelligence Unit.
- The company’s structure: in a recent note, Goldman Sachs pointed to "the complexity of Evergrande Group, and the lack of sufficient information on the company's assets and liabilities."
- Underlying risks in China: "The root of Evergrande's troubles — and those of other highly-leveraged developers — is that residential property demand in China is entering an era of sustained decline," Mark Williams, Capital Economics' chief Asia economist, said.
He added that Evergrande's collapse "would be the biggest test that China's financial system has faced in years.”
And many fear that if Evergrande sinks under its $300 billion debt, its failure would also affect the global economy.
What happens if Evergrande defaults?
For China, the biggest fear is a potential spillover effect that could hurt the wider Chinese economy.
Reportedly, Evergrande owes money to some 171 domestic banks and 121 financial firms. So if the company defaults, there will be consequences for the banking system.
And, apparently, Evergrande is only the tip of the iceberg: UBS estimates there are 10 property developers in potentially risky situations and with combined contract sales of 1.86 trillion yuan ($291 billion).
For the global economy… Well, it’s hard to tell.
Nobody really could predict the implications of the fall of Lehman Brothers — a global financial services firm — more than a decade ago. But we all know now how it played out.
Not everyone thinks Evergrande could repeat the Lehman scenario: “A possible Evergrande default could be a significant drag on the property sector. But we think it is far from being China’s Lehman moment,” said Barclays analysts in a note.
And yet, some countries have been ringing the alarm, sounding quite nervous:
- The Fed has warned that financial crisis in China could spill over into the U.S. markets because of the size and trade links between China and the world.
- US Treasury Secretary has said the following: “A slowdown in China, of course, would have global consequences. China's economy is large, and if China's economy were to slow down more than expected, it certainly could have consequences for many countries that are linked to China through trade.”
- Japan has stated, on its part, that it won't include Yuan-denominated investments in its $1.75 trillion government pension funds.
So, it looks like, with the Covid crisis and the shaky economic situation currently in place, the downfall of such a major actor in the global housing market could have strong ripple effects everywhere.
Maybe even for gold.
How can the Evergrande crisis affect gold?
It seems that the gold price has been more affected so far by traditional drivers like higher inflation or the U.S. dollar, than by the Evergrande crisis.
However, some analysts note that a potential slowdown in the global economy caused by the burst of China’s real estate bubble, could hurt the recovery from Covid-19 and set us back greatly.
This is why it will be important for investors to follow the development of this story, as it might have a serious impact on the global economy in the coming weeks and months.
And if things do get worse and aggravate the ongoing economic crisis, historical safe-haven assets such as physical gold, are likely to see an increase in demand from investors looking to protect their wealth.
Is your portfolio protected against this potential global economic crisis?