China has big problems. Debt failures have begun to metastasize. So far, the fear and uncertainty bred by successive failures has remained on the other side of the Pacific. With luck, it will remain there, but in finance these ills can travel over vast distances at lightning speed. Americans should hope that Beijing moves to alleviate the ill effects of these failures, or growing concerns of who will default next and on whom will become a problem for this country as well as China.
Certainly, the news coming out of China is disturbing. Evergrande, the giant property developer has made the biggest headlines, understandably since it is the largest of the troubled firms, but Evergrande is not alone. The first tentative signs of trouble emerged in August when Sunshine 100 China Holdings Ltd. defaulted on some of its dollar-based notes. It was weeks later that the much more significant Evergrande effectively announced that it was insolvent and failed to make an interest payment on a much larger issue of dollar-based debt. Hope of a resolution rose earlier this month when Hopson Development Holdings, a rival of Evergrande, floated the idea of buying Evergrande’s property management division. Should the deal go through, it might enable Evergrande to meet some of its obligations, but as of this writing, no deal has emerged.
In the meantime, a smaller real estate developer, Fantasia Holding Group, failed on October 4 to pay on a bond issue that had come due. During this same time, another property developer, Sinic Holdings Group, failed to make two domestic bond interest payments. Credit rating agencies began to downgrade much Chinese corporate debt to levels that point to default, while all eyes turned to some $229 million of the Beijing-based Xinyuan Real Estate Company’s dollar-denominated debt coming due.
Still more threatening is the likelihood that these firms are part of a larger group, many of which remain unknown. The pattern is well known. When any economy grows at the pace China’s did, the abundance of opportunities prompts mangers to borrow funds so that they can take advantage of those opportunities. Evergrande used debt to expand from its original base in Guangdong Province to pursue developments all over China as well as move into other lines of business. Other firms, it is now apparent, behaved similarly, if less grandly. As long as the economy developed at speed, revenue flows more than kept up with the debt burden. But when China’s economy began to slow, so did revenues, and those debts have become increasingly difficult to sustain. The growing list of defaults testifies to this reality and points to still more troubled firms than have yet made headlines.
The great danger here lies less in the tally of losses and more in the impact of these failures on the general level of trust in the financial system. Trust is an essential ingredient in finance. Without it, no participant can have any confidence that the person or firm with which he or she is dealing can meet their obligations. Without that confidence, people shy away from all activity. Trading, lending, stock purchases, whatever, then stops, and finance fails in its essential function, which is to channel funds from savers and investors to innovators and established firms. Expansion and hiring then also stop, and the economy collapses.
This risk, more than anything else, is why Washington acted as it did during America’s 2008-2009 financial crisis. The government extended credit to banks so that everyone else would have confidence that the banks were sound. The Fed flooded financial markets with liquidity at low interest rates so all would know that if anyone experiencing problems in a trade or loan could readily borrow on easy terms and meet their obligations. The idea was to protect the economy by re-establishing trust and confidence.
Beijing could follow the American pattern of 13 years ago, but there are better models. The ad hoc way the authorities proceeded then and seemingly random way they chose which firms to save and which to let fail did as much to create uncertainty as to relieve it. A better model might come from how Washington handled the savings and loan (S&L) crisis of the late 1980s or how Sweden handled its banking crisis in the 1990s. Instead of the policy melange pursued in 2008, each of these other approaches showed much more coherence and consistency. In the S&L crisis, Washington set up what it called the Resolution Trust Corporation (RTC). It took each failing firm, used its viable assets to meet what obligations they could and took the problematic paper onto its books to dispose of in the fullness of time after the panic had passed. The Swedes had a different institutional arrangement, but it did essentially the same thing.
With good luck, all this might be unnecessary, but patterns to date and China’s development history say that the likelihoods lie away from the good luck scenario. If Beijing acts to restore trust and confidence, it can save China a lot of financial pain and save its economy a recession. Though Beijing has no desire to help anyone else, by saving itself it might also save a measure of pain in this country and relieve Washington of the need to act.