The Great Recession, also known as the 2008 Recession, in the United States and Western Europe was triggered by a housing market collapse caused by a "subprime mortgage crisis."
Subprime mortgages are house loans given to people who have bad credit. Their mortgages are classified as high-risk. During the early mid-2000s housing boom in the United States, mortgage lenders wanting to profit from soaring house prices were less stringent in borrowers they approved for loans.
Financial institutions in North America and Western Europe purchased thousands of these mortgages in bulk, usually in the form of mortgage-backed securities, as an investment in the hopes of making a rapid profit.
The collapse of investment banking giant, Bear Sterns, was an early sign of what was about to unfold in market. The Lehman Brothers bankruptcy signalled the point where the recession commenced.
With a similar downfall of Evergrande, will there be a real risk of global financial contagion for the first time in 2008?
China has experienced some of the highest growth rates globally with a CAGR of 8.7 percent since the turn of the 21st century. A factor of the immense growth is their housing market which has been boosted for many years by the construction of an excess supply of housing units.
Real Estate makes up nearly 30 percent of China’s GDP compared with 19 percent for the US during its housing bubble. Evergrande is a major player in this market with an estimated 355 billion USD in assets spread across 1,300 complexes, making it China's second-largest property developer. It employs about 200,000 people and hires 3-4 million construction workers per year.
The rapid expansion of China's real estate market, similar to the US, was the seed of Evergrande's problems. The firm took out a series of loans and quickly grew, acquiring assets and capitalising on China's booming economy.
The Chinese government had recognised these looming concerns in the housing market and implemented efforts to curb excessive property borrowing through what is called "red lines" policy (Bloomberg, 2020). This policy aims to use the following requirements for property developers and curb a potential credit crunch:
Evergrande, not being able to satisfy the requirements, has found itself in a precarious position. The company is the most indebted property developer, with liabilities on its balance sheet equaling roughly 2 percent of China's yearly GDP.
With upcoming bond payments, Evergrande is in a scurry to obtain money to pay its many lenders and suppliers. There have been major fears that the company's downfall might have a negative impact on other businesses due to its sheer size and the economy as a whole, possibly leading to a credit crunch locally and globally.
This prompted investors globally to panic-sell. On Monday October 20th, Dow Jones plunged more than 800 points, the S&P 500 down as much as 2.4 percent and Hong Kong's Hang Seng stock index tumbled 3.3 percent, as investors braced for a big week in which Evergrande could default. This panic was realised in other financial markets; bitcoin and ether dropped more than 5 percent as risk-off sentiment spread to crypto.
The current market sentiment is that Evergrande is too big to fail. The People’s Bank of China has relieved the financial markets and has reduced the possibility of a default and any spillover contagion by executing the equivalent of 17 billion USD in the form of 7 and 14 day reverse repurchase agreements.