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Why I think Evergrande shares caused a FTSE 100 drop yesterday

Portrait of construction engineers working on building site together
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Evergrande (SEHK: 3333) shares have plunged 88% from 19.60HKD in the past year to 2.27HKD today. As China’s second-largest property developer, this is a worrying indicator for the country’s economy.

Meanwhile, the FTSE 100 index suffered a 1% drop as UK investors worry about the ramifications of Evergrande’s potential collapse. So what’s going on?

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Evergrande shares crisis explained

Over the past few years, Evergrande has borrowed $300bn to finance an expansion campaign. This made it the most indebted real estate developer in the world. However, it’s fairly common for growth stocks like Evergrande to take on debt to accelerate an expansion. And most of the time, the plan works. Otherwise, financial institutions wouldn’t lend the money.

However, the Chinese government recently legislated to control the amount of land that any individual company can own. Suddenly, Evergrande was forced to back-pedal on its plans. And recently, it’s been forced to offer properties at discounts to pay off investors in order to stave off bankruptcy.

There’s now interest payments of $84m due on its bonds on Thursday. It’s possible that Evergrande shares will become worthless if it defaults. Multiple global credit rating agencies have already lowered their ratings of its bonds. For example, Fitch has lowered its rating from CC to CCC+, indicating that a default is very likely. 

Why so serious?

The company owns 1,300 building developments across China. But it is also involved in electric cars, food and drink manufacturing, and wealth management. It owns Guangzhou FC, one of China’s most famous football teams. So its collapse would hit multiple sectors of the Chinese economy.

And many customers put down deposits for their properties before construction had even started. But it seems likely these people will lose their money. The same goes for the hundreds of companies that rely on Evergrande for business. Material suppliers, architects, and designers could all be forced into bankruptcy.

But the most catastrophic potential effect is that Evergrande’s collapse could set off a global stock market crash. The company owes money to around 300 financial institutions, who up until recently could be confident the money would be repaid. But if Evergrande collapses, Chinese banks will be unable to lend out enough money to maintain liquidity in the Chinese economy. And companies who unexpectedly lose their credit lines will be at risk of contraction or collapse. For me, there’s echoes of the credit crunch of 2008.

The bottom line 

The question is whether Beijing will save Evergrande from collapse. Analysts are conflicted, because a collapse would lead to immediate economic suffering on top of the pain caused by the pandemic. However, a rescue would involve the Chinese government accepting a portion of the blame. And it would be saving a failing company from large corporate debt, while simultaneously pursuing a corporate debt reduction campaign.

But Chinese and foreign investors could be deterred from investing in Chinese companies by Evergrande’s potential collapse. It’s another warning sign to add to a growing list. UK investors are also concerned about the labour shortage, the gas crisis, the delta variant, and the lingering trade issues caused by Brexit. I’m not surprised that the FTSE 100 had a wobble yesterday.

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Charles Archer has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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