A financial crisis made in China? by Paola Subacchi



Since the 2008 global financial crisis, China’s financial system has grown to become systemically important. Yet it is uncertain whether the international financial safety net has the resources to protect the world from associated risks.

LONDON – As the International Monetary Fund and the World Bank prepare for their annual meeting next week, all eyes are on Evergrande, China’s second-largest real estate developer, who apparently cannot repay the roughly $ 300 billion he owes. currently to banks, bondholders, employees and suppliers. As the real estate giant is on the verge of bankruptcy, the world is forced to consider a scenario it never seriously considered: a financial crisis made in China.

Observers quickly drew parallels between the Evergrande debacle and past crises. Some compare it to the 2008 crash of US investment bank Lehman Brothers, which sparked a massive banking and financial crisis. Others remember the near collapse of the Long-Term Capital Management hedge fund in 1998, which was only averted by a bailout from the US Federal Reserve to protect financial markets. Still others evoke the collapse of the Japanese real estate bubble in the 1990s.

In all of these cases, the combination of excessive leverage and overvalued assets triggered instability. But none really offer a glimpse of the situation in Evergrande, due to the peculiarities of China’s banking and financial system, which is driven by politics and not the markets.

While a country like the United States may provide a bailout when financial collapse appears imminent, China intervenes regularly in capital markets and tolerates little risk to financial stability. China’s monetary authorities are therefore in a good position to deal with the financial woes of domestic firms, shield distressed firms from contagion, ensure low borrowing costs, and provide selective bailouts.

By organizing such bailouts, Chinese authorities are unlikely to question whether a company is really “too big to fail,” as the US authorities did at the time before Lehman’s bankruptcy. Brothers. China would much rather risk moral hazard than jeopardize financial stability.

Given this, it’s probably safe to assume that China will step in to deal with the collapse of Evergrande. But the episode will nevertheless leave two major scars on the Chinese economy.

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First of all, as foreign investors will not be immune, confidence will suffer a little, especially in the Chinese offshore credit market, which is particularly exposed to the risks of Evergrande. China’s unwanted dollar bond yields jumped to around 15%, their highest level in about a decade.

Since its creation in 2010, the offshore market has been at the heart of China’s strategy to make the renminbi a liquid and freely usable international currency, as it allows to bypass national capital controls. But foreign investors have been extremely cautious about trading renminbi-denominated assets in this market. The Evergrande saga will reinforce their fears, at least for now, forcing China to rethink its renminbi strategy.

The second scar will be on China’s real economy. The real estate sector accounts for nearly 30% of China’s GDP, compared to 19% in the United States. And real estate added value contributes around 6.5% to China’s GDP. (If indirect contributions, such as fixed capital investments, are taken into account, the sector’s contribution to Chinese growth is even greater.)

The implosion of Evergrande could therefore have serious consequences for jobs and growth. If it triggers a drop in stock and real estate prices – housing represents 78% of Chinese assets, against 35% for the United States – consumer confidence, and therefore consumption, could also suffer.

The question is whether China will be able to contain the Evergrande crisis and prevent its consequences from spreading to global financial markets. So far, China is expected to be successful in containing the problem. Even if Evergrande collapses, according to logic, China’s banking and financial system is robust and resilient enough to withstand it. Moreover, the policy response to any instability would most likely be effective, matching in speed and breadth the Fed’s decision in 2008 to support the US banking system. Several policy tools, including monetary and fiscal easing, are available.

But there is no guarantee that the political response will not lag behind events, as political considerations may hinder action. In this case, the rest of the world would feel the effects.

Since the 2008 global financial crisis, China’s financial system has grown to become one of the largest in the world, with financial assets accounting for nearly 470% of GDP. And it has become more integrated with the rest of the world through investment flows and direct loans. But while China’s financial system is now systemically important, it is uncertain whether the international financial safety net – provided by multilateral financial institutions, notably the IMF – has expanded enough to accommodate this.

This safety net is currently estimated at around $ 2.7 trillion (based on immediately available financial resources, not including pre-committed resources). That’s less than China’s foreign exchange reserves – currently around $ 3.2 trillion. Would this be enough to avoid catastrophe in the event of a systemic crisis made in China? Would the United States – the main shareholder of the IMF – even agree to the Fund providing adequate assistance and resources to deal with 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 occurred in the past two decades? At the very least, the Evergrande crisis should get us out of our complacency with global financial risks. We need to build resilience, not politicize the multilateral financial architecture. And if a systemic financial crisis hits China, we need to know who will step in to save the rest of the world – and how.


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