With the impending failure of Evergrande, China’s real estate giant, it is useful to review what is at stake for China and for any financial system facing this problem.
The issue has only partly to do with the size of the firm that is in trouble, and even less to do with its financial misdeeds. Rather, the crucial consideration is the impact such a failure could have on trust in the financial system. Trust is the essential ingredient: If participants in the system lose confidence that the person or firm they are dealing with can meet their obligations, then trading, lending, stock purchases –– all financial dealing –– comes to a halt. Finance then fails in its essential function, which is channeling funds from savers and investors to innovators and established firms. Expansion and hiring also stops, leading toward economic collapse.
This is what threatened the United States during the 2008-09 financial crisis. Everyone knew that the American economy could have absorbed the mortgage losses, large as they were estimated to be. But because no one could tell who held those bad mortgages or where, everyone pulled back from dealing with everyone else. For instance, a borrower who had a good credit history might have acquired some of the failing mortgages and thereby brought himself to failure. Or even if he himself did not hold any of the questionable mortgages, he might have depended on someone who did hold some of them, passing the failures through onto the presumably sound borrower.
More than anything else, the concern over how this loss of trust could impact the U.S. economy is why Washington and the Federal Reserve (Fed) stepped in to help financial institutions meet their obligations –– the government by extending credit to banks, so that everyone else would have confidence that the banks were sound, and the Fed by flooding the financial markets with liquidity at low interest rates so that those involved in a trade or loan, if they experienced problems, could readily borrow on easy terms and meet their obligations. The idea was to protect the economy by re-establishing trust and confidence.
Probably, the U.S. authorities could have done a better job than they did. They delayed at first, and their ad hoc way of proceeding and their seemingly random selection of which firms to help and which to let fail did as much to destroy trust as to recover it. But they did succeed in stemming the panic. Even so, the United States suffered the worst recession since the Great Depression.
In China, Evergrande has already failed to meet some of its obligations. Because it is such a huge firm, knowledgeable observers suspect that its financial obligations to lenders, investors, customers, and suppliers are widespread. At least three other, albeit smaller, firms have failed to redeem bonds on schedule or make interest payments on time. There is also a sense that there are other firms in China that, like Evergrande and these three, have overused debt during the great growth period of the country’s economy and accordingly are in a similar perilous situation. The stage is now set among financial players, both in China and the rest of the world, for a loss of trust. Beijing must act to restore that essential trust. The moral scolding on which so much of China’s leadership has depended is now secondary. Blame and punishment can come in the fullness of time, but the present moment is a time for action –– for Beijing to use official and central bank funds to reassure all that, whomever they are dealing with will likely meet their obligations.
American investors should hope that Beijing acts. Though China is the epicenter of problems right now, the fears of default that destroy trust can travel quickly if not met by prompt action and can easily cross the Pacific into the United States. As noted, Evergrande and two of the other failing Chinese firms have already failed to pay interest payments on dollar-based debt. If Beijing fails to act, and the trouble comes here, Washington will have to act.