Why Australia isn't immune to China's Evergrande collapse

China's Evergrande Group is in a liquidity crisis that, save for a bailout by the Chinese government, threatens to set off a chain of events that echo the 2008 global financial crisis. And Australia isn't immune.

What happened?

As with any corporate credit crisis, the fundamentals are relatively simple: a large company's debt obligations have outstripped its capacity to meet them.

Evergrande, the world's second-largest property developer, expanded aggressively by borrowing aggressively.

That's putting it mildly. It has estimated total debts of about $419 billion, which amounts to one of the largest debt piles in the world.

Last year, China introduced new rules that limited how much money big real estate developers could borrow.

As a result, Evergrande slashed the price of its properties in an attempt to drive sales and pay down debt.

Now, the company is having trouble meeting the interest payments on all its debt.

Who holds the debt?

Evergrande is in the hole with virtually everyone.

It owes money to Chinese banks, foreign hedge funds, suppliers, private investors, even its own employees, to say nothing for the 1.6 million apartments it owes customers.

The company used every trick in the book to raise funds in its attempt to expand. It went to the banks. It went to institutional investors. And it also concocted up wealth management products offering 12% yield that it sold to employees and even the buyers of its own properties.

"My parents put the bulk of their savings, which is Rmb200,000 [AUD$42,600] and not a lot by Evergrande's standard, into its [wealth management products]," a daughter of one investor has been reported as saying.

"They wouldn't have trusted Evergrande's wealth products had they not bought the developer's apartment."

Things are so bad that Evergrande is now offering its investors property in lieu of cash.

The next big test will come on Friday, when interest on two of Evergrande's bonds comes due.

Will there be a run on the banks?

Talk about this being a repeat of the 2008 Lehman Brothers collapse is premised on the systemic nature of the debt. It's everywhere.

"The financial fallout would be far-reaching," the Economist Intelligence Unit's (EIU) Mattie Bekink told the BBC.

"Evergrande reportedly owes money to around 171 domestic banks and 121 other financial firms."

The fear is that this could lead to a run on the banks.

Banks lend out much more money than they borrow from depositors, the idea being that the money that has been lent to the banks will never be withdrawn all at once. A bank may lend out $10 for every $3 it has in liquid assets, with the hope that it will never cop more than $3 in withdrawals at any one time.

If more money is withdrawn than a bank has in liquid assets, then the bank will fail.

This fear of failure adds fuel to the fire. Depositors withdraw their money en masse to recover it before the bank goes under, in turn hastening the collapse of the bank.

When things get to this point, the only hope is that the government comes to the rescue with some sort of bailout for the banks of Evergrande. This is what we saw during the global financial crisis, and why the US government was forced to lend hundreds of billions to Wall Street.

This action saved the world from another great depression but came at huge political cost because it was seen as a reward to Wall Street for screwing main street. Less commonly known is that these bailout loans have since been paid back to taxpayers, to the tune of almost US$100 million in interest.

Is Evergrande too big to fail?

If there is a run on the banks, all bets are off.

"Just like iron ore, the market continues to discount the risk created by Evergrande and other mega property developers in China," says Mathan Somasundaram, CEO of Deep Data Analytics.

"Property is a global asset bubble artificially boosted by Governments and Central Banks to cover the economic structural problems."

The question is: does Beijing consider Evergrande too big to fail?

"...there are always too many vested interest groups to let the game end," says Somasundaram.

Still, Beijing has so far maintained radio silence. But a bailout may be anathema for a government intent on regulating its turbocharged economy.

"The difference in China is that no one is too big to fail. Chinese government may let Evergrande fall into default."

Fortunately, the Chinese government has the economic levers to save the day thanks to its so-called system of authoritarian capitalism. Unlike the United States, it doesn't need to get the tick of approval from a democratically elected Congress.

But doing so would risk ingraining moral hazard: if big companies expect to get bailed out because they're too important to fail, then they'll continue taking outsized risks.

But the bailout could be performed in a roundabout way that still holds Evergrande accountable.

"They will have plenty of time to organize shadow bailout for local investors and/or competitors to take over projects at a discount," says Somasundaram.

How will this affect Australia?

The main exposure to Australia is iron ore, and any equity tied to it. It's our largest export and China is our number one customer.

"The most notable local market development last week was the further slump in iron-ore prices on the back of China's continued clamp down on steel production and mounting concern over the property sector," says Betashares chief economist David Bassanese.

"In turn, that has seen local resource stocks underperform relative to financials."

AMP chief economist Shane Oliver believes we should be alert but not alarmed.

"Since July, the iron ore price has more than halved reflecting Chinese constraints on steel production, the slowdown in its economy and recent concerns about the flow on to construction-related demand from property developer China Evergrande Group's problems," he says.

"But bear in mind that the iron ore price has fallen from levels no one ever thought it would get to and is still very high and well above cost. This will dent Australia's national income and current account surplus and add a new blowout in the Federal Budget deficit (which along with lockdown support payments may end up closer to $150 billion this year than the $107 billion in the May Budget)."

At the end of the day, the situation is in the hands of the Chinese government. If it intervenes, which looks likely, then this could all wash over. But if it wants to avoid the moral hazard of a bailout, then buckle up your seatbelts.

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