I have experienced a few high profile bankruptcies in my time.
I worked on Wall Street when the Russian government defaulted on its debt, triggering the implosion of the highly leveraged hedge fund Long Term Capital Management. Ditto when Enron turned out to be primarily an accounting fraud. Each of them was serious in their own way and treated as such. To contain the fallout from LTCM, then Fed Chairman Alan Greenspan brought together all of his major lenders in a room to agree on a common mechanism to unwind this risk; after the collapse of Enron, Congress passed the Sarbanes-Oxley Act to strengthen corporate governance. None has led to widespread economic collapse.
I left Wall Street when the Lehman Brothers bankruptcy triggered a real financial crisis that ushered in the Great Recession. How was this bankruptcy different and what are the implications for the possible collapse of Evergrande, the Chinese real estate conglomerate on the brink of bankruptcy?
One answer is that by letting Lehman Brothers collapse, the government has unleashed widespread panic over its effect on money market funds. Lehman has issued many short-term debts in the course of his day-to-day operations, and money market funds – which are meant to be functionally equivalent to savings accounts, a vehicle that paid variable interest but whose principal did not was not at risk – owned a huge percentage of that debt. When Lehman went bankrupt, the principal of these funds fell below par, triggering the equivalent of a widespread run on the banks, putting the financial system in free fall.
This problem could have been avoided if the government had taken control of Lehman Brothers, wiping out its equity investors but guaranteeing its short-term debt. Lehman was not “too big to fail” – he was simply too big to fail without proper planning to protect the financial system from the consequences of failure. And if Lehman had been the isolated case of a large, poorly run company, this could also have been resolved through other means, each of which would have been the end of the story, just like with LTCM and Enron.
But Lehman was not an isolated case. The problem was much more fundamental: the entire financial system was dragged into a huge real estate bubble, and that bubble had started to burst. Supporting the bubble itself would have been a mistake if it had been possible, but given the magnitude of the leverage, the entire financial system was in jeopardy. The problem was systemic and required a systemic solution.
And we had one – but its terms had profound consequences over the next decade and beyond. In the United States, the bailout of the financial system kept most of the major banks afloat and prevented a much deeper recession. But owners have largely been left behind, and inflation has been left well below trend for years. The result was a slow and uneven recovery that fueled a policy of zero-sum resentment. In Europe, the focus has been on protecting German banks and the value of the euro at the expense of workers in Spain, Italy and Greece, a set of policies that have fueled left and right populism. and put the European Union under enormous structural pressure. .
These are also the important questions concerning Evergrande. Yes, that would be a very big bankruptcy, but even a $ 300 billion debt is relatively small in the context of a $ 16 trillion economy. If the only problem is to unwind this debt in an orderly fashion and protect the financial system, China has all the tools it needs. .
The real danger comes from how systemic the problems plaguing Evergrande are – and, if they are, how the Chinese government will approach them.
There is ample evidence that these problems are systemic and serious. Beijing’s development model transforms the extremely high national savings rate of Chinese citizens into physical capital: power plants, roads, railways and especially housing, to facilitate China’s transformation from a predominantly rural society into a predominantly one. urban. However, when these projects no longer had clear arguments to be economically viable, China continued to develop. As a result, they over-built so much that we started to talk about “ghost towns”, entire municipalities without inhabitants. While some of them have started to attract residents and businesses, the surplus is still huge. But despite the government’s efforts to encourage rental, real estate has remained a favored investment for Chinese families, in part because they have few other options: bank deposits have very low returns, the stock market is considered corrupt and capital controls prevent investment outside of China.
It describes a classic real estate bubble, and Evergrande is centrally exposed to it. China may want to punish Evergrande for warning other companies to improve their financial management, but if the bubble starts to burst, even if contagion is prevented, these other companies will have no way out. And individual owners, of course, will have the least recourse of all.
Ultimately, the risk is with the Chinese political and economic model itself. Ten years ago, the Chinese Communist Party could say that, regardless of its other failures or oppressive characteristics, it offered a vastly increased standard of living, as well as certain freedoms. The scope of these freedoms steadily narrowed during the Xi years, and economic growth also slowed. Beyond the short-term risk of unrest from angry bondholders, if the main mechanism of wealth creation – the value of housing – is reversed, what can the regime point to as legitimacy? And what will happen to its business model if ordinary people wonder why they work so hard and save so much? Beijing can make a vivid example of a few real estate moguls and business executives to show that they are on the side of the people, but you can’t eat schadenfreude.
Critics from China either, however. The country that invented the non-fungible token is in a bad position to lecture anyone about speculation, and those who have consistently bet against the Chinese model have been losing for 40 years. Chinese leaders are clearly aware that they have a problem, in Evergrande in particular and in the real estate market more generally. This is always the first and most important step in finding a solution. Despite the growing tension between our countries, we have no reason to hope that they will not do so.