China's Real Estate sector is described as the most important area of the Chinese economy. With the addition of civil engineering and other goods and services related to real estate and construction, this segment accounted for approximately 23.6% of China's GDP in 2021, according to analysts at investment bank Goldman Sachs. Investors therefore see the recovery of this sector as key to the recovery of the world's second largest economy after three years of isolation due to the coronavirus pandemic.

For many years, China's economic growth has been underpinned by a thriving real estate sector driven by population expansion. This housing market not only created employment opportunities but also acted as a means of preserving wealth for the expanding middle class. In addition, local governments relied on revenue from land sales. However, the country's population no longer grew as rapidly as it once had, and the prolonged period of Covid-19 deeply affected consumer behaviour in China. This combination of factors has led to developers facing significant debt and an overhang of supply of new housing units.

In 2020, the Chinese authorities launched a campaign against irresponsible borrowing and forced developers to reduce their debt burden. This initiative has resulted in problems for highly indebted companies such as Evergrande and Country Garden. Another important factor in the Chinese property market is the widespread practice of pre-selling new properties. In this practice, buyers must pay the full amount before construction, providing developers with interest-free financing. This system has long flourished due to stable prices and market confidence, but falling property values and stalled projects are now making buyers reluctant to pay mortgages on properties they have not yet seen. More than 50 developers in China have had trouble meeting their payment obligations in the past three years, according to Standard & Poor's data.

Evergrande was once one of the largest developers in the world, but in 2021 it has captured the world's attention with the apparent threat of imminent collapse. As of June this year, it had posted losses of USD 81 billion for the previous two years, and the company still carries a substantial debt burden of USD 334 billion, equivalent to around 2% of China's GDP. Last month, when trading resumed after a hiatus of almost a year and a half, Evergrande's shares plunged by as much as 87%. Moreover, the company has postponed key restructuring talks with its creditors and filed for Chapter 15 bankruptcy protection in the US.

Country Garden, which is among the 1,000 most valuable global companies, has also seen its valuation drop significantly due to a 75% drop in earnings between 2019 and 2022. The company's current financial woes came into focus when it defaulted on two US dollar-denominated bonds in August. Country Garden has openly admitted that it is struggling with liquidity issues and is forecasting a significant loss for the first half of the year. The eventual default of this 31-year-old developer could have a more serious negative impact on the Chinese economy than the consequences arising from Evergrande's debt problems. Although Country Garden's total liabilities of approximately USD 191.7 billion are lower than Evergrande's, it is involved in 3,121 projects in all Chinese provinces, while Evergrande is involved in approximately 800 projects.

Problems are also emerging in other areas of financial assets in China. In recent weeks, three listed companies have revealed that they have not received payments originally promised for wealth management products sold by Zhongrong International Trust, which is linked to Chinese conglomerate Zhongzhi Enterprise Group. These instances of missed payments have raised concerns among investors about China's large trust sector, which has historically served as a source of funding for developers.

Meanwhile, Chinese households are hesitant to invest in new housing due to falling property prices and the current state of the economy, which is struggling with lower consumer spending, increased youth unemployment and potential liquidity problems in the financial sector. Moreover, recent data show that the Chinese economy is at risk of deflation and that households that have accumulated large savings are also borrowing less. As a result, the Chinese real estate sector has been in an unprecedented downturn over the past two years. Real estate investment in China fell by 8.5% year-on-year in the first seven months of this year.

These recent developments underscore the real risk of a recession in China. It points to concerns about deflation, reduced consumer spending and an overall weakening of Chinese economic growth. It is important to note that China, which is the second largest market after the US in gross domestic product, occupies a key position as a market for many US and European businesses.

"The ongoing crisis in China's real estate sector is a clear reminder of the complex relationship between many economic factors. With the worrying spectre of deflation looming, combined with a fall in consumer spending and a general weakening of economic growth, the fallout from this downturn has the potential to spread far beyond the property market. As China struggles to navigate these troubled waters, businesses around the world are bracing for the potential consequences."

-Miroslav Linhart, Managing Partner, Financial Advisory Services, Deloitte Czech Republic