- On 20 September, global stock markets fell on the risk of default at Evergrande, one of China’s largest property developers.
- The company had piled up very high debt and investors feared it could not meet its payments.
- The problem is not only how much debt there is, but when it must be repaid: a sound asset with fragile financing is still fragile.
On 20 September 2021, global stock markets fell on the risk of default at Evergrande, one of China’s largest property developers. The company had accumulated very high debt and investors feared it could not meet its payments, with possible effects on the financial system. Fear of contagion moved markets around the world within hours. Investors wondered how far the consequences might reach.
For those far from China, the case may seem a distant story. But financial markets are connected, and doubt over a large, heavily indebted company in a country that weighs so much in the world economy was enough to unsettle investors in Europe and America. Whatever eventually happened to the company, the episode left a basic lesson about the fragility that excess debt can hide.
What happened
A property developer builds and sells homes and other properties, and usually finances itself with debt to advance construction costs. Evergrande had grown on a very high level of borrowing. When doubts arose about its ability to pay, investors began to fear a default, that is, that the company could not repay what it owed within the agreed time.
Fear of contagion moved markets around the world. When a large indebted company is in trouble, those who have lent it money, whether banks, funds or bondholders, may suffer losses, and that possibility extends to other companies in the same sector or country. This is what is known as contagion risk, and it explains why a local piece of news can have global repercussions.
When debt weighs too much
A heavily indebted company is vulnerable when its financing becomes difficult or when the sector in which it operates cools. What seems sustainable while all goes well can quickly cease to be, because debt maturities do not wait for sales to recover. When a payment date arrives and there is no liquidity, having valuable assets is not enough: they must be convertible into cash.
The problem is not only how much debt there is, but when it has to be repaid. Long-term debt with stable income can be perfectly manageable, whereas short-term debt with uncertain income can be unsustainable even if the amount is smaller. To assess the soundness of any company or portfolio, one has to look at the payment schedule as much as at the balance. It is worth ordering maturities by date and comparing them with the expected income for each period.
Property has risks too
The case was a reminder that property, regarded as the safest asset, can also become a source of crisis when financed with too much debt. For a family or company with properties, it is worth reviewing the level of leverage, the capacity to meet payments if income falls and the ease with which assets could be sold in case of need.
A few simple questions are worth asking: what part of the value of the portfolio is financed with loans, what would happen if rental or business income fell for a while, and how much room for manoeuvre is left before having to sell. A sound asset with fragile financing is still fragile, and reviewing the debt structure in time is one of the best ways of protecting oneself. Talking to the bank before tension arises makes it easier to renegotiate on better terms.
The soundness of a portfolio is also measured by how it has been financed.
This article is general information. It is not legal, tax or investment advice, and it does not take anyone’s particular circumstances into account.
