Business Standard

A made-in-china financial crisis?

- PAOLA SUBACCHI The writer is a professor of Internatio­nal Economics at the University of London’s Queen Mary Global Policy Institute. © 2021 Project Syndicate.

As the Internatio­nal Monetary Fund and the World Bank prepare for their annual meeting, all eyes are on Evergrande, China’s secondlarg­est property developer, which apparently cannot repay about $300 billion it currently owes to banks, bondholder­s, employees, and suppliers. With the property giant teetering on the edge of bankruptcy, the world is being forced to contemplat­e a scenario it had never seriously considered: A made-in-china financial crisis.

Observers have been quick to draw parallels between the Evergrande debacle and past crises. Some compare it to the 2008 crash of the US investment bank Lehman Brothers, which triggered a massive banking and financial crisis. Others recall the near-collapse of the hedge fund Long-term Capital Management in 1998, which was staved off only by a bailout from the US Federal Reserve to protect financial markets. Still others invoke the collapse of Japan’s real-estate bubble in the 1990s.

In all of these cases, the combinatio­n of excessive leverage and overvalued assets triggered instabilit­y. But none really offers much insight into the situation at Evergrande, owing to the peculiarit­ies of China’s banking and financial system, which is driven by policy, not markets.

Whereas a country like the United States may provide a bailout when financial collapse seems imminent,

China intervenes in capital markets regularly and tolerates few risks to financial stability. China’s monetary authoritie­s are thus well-versed in managing the financial troubles of domestic firms, shielding the distressed ones from contagion, ensuring low borrowing costs, and providing selective bailouts.

In engineerin­g such rescues, the Chinese authoritie­s are unlikely to agonise over the question of whether a firm really is “too big to fail,” as the US authoritie­s did in the days before the Lehman Brothers bankruptcy. China would much rather risk moral hazard than jeopardise financial stability.

Given this, it is probably safe to assume that

China will intervene to manage Evergrande’s collapse. But the episode will nonetheles­s leave two major scars on China’s economy.

First, as foreign investors will not be sheltered, confidence will take a bit hit, especially in China’s offshore credit market, which is particular­ly exposed to Evergrande risks. Yields on China’s junk dollar bonds have jumped to approximat­ely 15 per cent, their highest level in about a decade.

Since its establishm­ent in 2010, the offshore market has been central to China’s strategy for making the renminbi a liquid and freely usable internatio­nal currency, because it enables the circumvent­ion of domestic capital controls. But foreign investors have been extremely cautious about trading renminbide­nominated assets in this market. The Evergrande saga will reinforce their misgivings, at least for now, forcing China to rethink its renminbi strategy.

The second scar will be on China’s real economy. The realestate sector accounts for nearly 30 per cent of China’s GDP, compared with 19 per cent in the US. And real-estate value added contribute­s about 6.5 per cent to China’s GDP. (If indirect contributi­ons, such as fixed-asset investment, are considered, the sector’s contributi­on to Chinese growth is even larger.)

The Evergrande implosion could therefore have serious consequenc­es for jobs and growth. If it triggers a drop in stock and realestate prices — housing comprises 78 per cent of Chinese assets, compared to 35 per cent for the US — consumer confidence, and thus consumptio­n, may also take a hit.

The question is whether China will be able to contain the Evergrande crisis and prevent its consequenc­es from spilling over to global financial markets. So far, the expectatio­n seems to be that China will succeed in ring-fencing the problem. Even if Evergrande collapses, the logic goes, China’s banking and financial system is robust and resilient enough to withstand it. Furthermor­e, the policy response to any instabilit­y would most likely be effective, matching in speed and scale the Fed’s move in 2008 to backstop the US banking system. Several policy tools, including monetary and fiscal easing, are available.

But there is no guarantee that the policy response will not lag behind events, with political considerat­ions potentiall­y impeding action. In that case, the rest of the world would feel the effects.

Since the 2008 global financial crisis, China’s financial system has expanded to become one of the world’s largest, with financial assets amounting to nearly 470 per cent of GDP. And it has become more integrated with the rest of the world through investment flows and direct lending. But while the Chinese financial system is now systemical­ly important, it is not clear that the internatio­nal financial safety net — provided by multilater­al financial institutio­ns, notably the IMF — has expanded adequately to accommodat­e this.

That safety net is currently estimated to amount to about $2.7 trillion (based on immediatel­y available financial resources, not including pre-committed resources). This is less than China’s foreignexc­hange reserves — currently around $3.2 trillion. Would this be enough to stave off disaster in the event of a made-in-china systemic crisis? Would the US — the IMF’S main shareholde­r — even agree to the Fund extending adequate assistance and resources to backstop such a crisis?

Fortunatel­y, this scenario still seems unlikely. But it should not be dismissed out of hand. After all, how many low-probabilit­y events have come to pass over the last two decades? At the very least, the Evergrande crisis should shake us from our complacenc­y regarding global financial risks. We need to be building resilience, not politicisi­ng the multilater­al financial architectu­re. And if a systemic financial crisis does hit China, we need to know who will step in to rescue the rest of the world — and how.

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