Evergrande ≠ Lehman | Financial Times

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In case you hadn’t noticed, or hadn’t bothered to read Alphaville, Monday was a bruising one for stocks. On the continent, the Stoxx 600 closed down 1.7 per cent on the day, its sixth worst day of the year, with German bourse the Dax taking the most pain with a fall of 2.3 per cent. In the land of the free (underwritten by VCs), the S&P 500 dropped 1.7 per cent also, with mega cap tech, small caps and cyclicals bearing the most pain.

Why? Well, it seems the world has woken up to the liquidity problems at Evergrande — China’s largest, and most indebted, real estate developer. As we wrote only yesterday, the company has been in trouble for some time, so the question now is whether its troubles spill out into the broader market, or are relatively contained within the Chinese property and financial sector.

In other words, is this a Lehman moment?

If you read the news you may have noticed rather a few breathless articles comparing the crisis to the former US investment bank run by the charming Dickie Fuld (h/t Bloomberg’s Dani Burger for that data point).

And sure, the timing — September — is similar, granted. But according to Ajay Rajadhyaksha and his team at Barclays, the two meltdowns could not be more different.

Why? It’s all to do with liabilities. Here’s the key blurb:

This, in our view, is the most important reason the parallels with Lehman are overblown. Quite simply, financial crises are liability-side driven. They start on the asset side, but then morph into a crisis when lenders pull away. Consider the Lehman case. Across late 2007 and into 2008, markets worried about the quality of Lehman’s assets (most prominent was the $23.7bn leveraged buyout of a large portfolio of apartment buildings – Archstone – which was ultimately sold in 2012 for just $6.5bn). But in response to these fears on the asset side, something else had to occur; in late summer 2008, the wholesale funding markets turned on Lehman. Banks refused to face Lehman as a counterparty or extend credit. The firm suddenly couldn’t roll over commercial paper, and then counterparty risk exploded, as banks became fearful of each other. And with the US sovereign unable/unwilling to step in to backstop Lehman’s liabilities (or inject new equity) and focused on the ‘moral hazard’ associated with bailing the firm out, Lehman defaulted on its liabilities (off- and on-balance sheet) sparking a full-fledged financial crisis.

China’s situation is very different. Not only are the property sectors’ linkages to the financial system not on the same scale as a large investment bank, but the debt capital markets are not the only, or even the primary, means of funding. The country is, to a large extent, a command-and-control economy. In an extreme scenario, even if capital markets are shut to all Chinese property firms (which is not occurring and is only a tail risk at this point), regulators could direct banks to lend to such firms, keeping them afloat and providing time for an extended ‘work-out’ if needed. The only way to get a widespread lenders’ strike in a strategically important part of the economy would be if there were a policy mistake, where the authorities allow the chips to fall where they may (perhaps to impose market discipline), regardless of the systemic implications. And we think that’s very unlikely; the lesson from Lehman was that moral hazard needs to take a back seat to systemic risk.

We don’t mean to imply that China has succeeded in suspending the laws of economics. If an asset can’t fully service the underlying debt, it of course matters. But the economics can show up through either a one-time (violent) balance sheet adjustment – aka a financial crisis – or through many quarters of income statements (a debt bubble being deflated). We also don’t mean to suggest that China could never have a Lehman moment. But with the banking system likely to be pressed into service as a funding source in the event of real stress, China would likely face a ‘true’ financial crisis only if its banks had funding problems. This risk was high in 2015, when the country saw over a trillion dollars of capital flight, meaning there was something of a ‘run’ on the domestic financial markets as a whole. But as we argued in China Financial systemic risks: why 2020 is not 2015, Thinking Macro, Feb 24, 2020, policymakers are now attuned to, and in control, of this risk.

A prospective Evergrande default is still a serious issue. But, we think, the effects are primarily on growth, and unlikely to be exacerbated by a financial crisis. This is a challenging moment for Chinese authorities but to our mind it is far from being China’s Lehman moment.

Thoughts welcome below.