The relative calm in markets after China Evergrande Group missed payments on investment funds suggests Beijing has, so far, avoided a “Lehman moment.”
That could always change, of course. But investors appear to be giving President Xi Jinping’s government the benefit of the doubt. The bet is that Chinese officials will keep Evergrande from crashing the global economy the way the collapse of Lehman Brothers did in September 2008.
There’s another mistake Beijing may be making—one with parallels dating back to 1998. A decade before Lehman failed, down to the month, the Long-Term Capital Management collapsed. The Connecticut-based hedge fund founded by John Meriwether was caught badly positioned when Russia’s default slammed global debt markets. And in some ways, the firm’s collapse was thought to threaten several asset classes.
The lessons from the LTCM debacle are the real ones China needs to internalize as 2022 approaches.
First, a quick reminder of how the 1998 to 2008 period unfolded in the U.S. LTCM’s blowup led to one of modern history’s most dramatic bailout efforts. At the time, then-Federal Reserve Chairman Alan Greenspan and his team were convinced letting that single fund fail would tank global markets.
The New York Fed, in turn, staged an extraordinary intervention to save Salomon Brothers alumnus Meriwether and avoid financial Armageddon. The deal saw 14 financial institutions pony up $3.6 billion to facilitate the process, an unthinkable sum back in 1998.
A week later, Greenspan faced skeptical lawmakers on Capitol Hill. As he explained it in October 1998: “Had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own.”
Fair enough. Until you consider the bubble in so-called moral hazard that bailout generated. The message investors everywhere heard loud and clear was not to worry. If a systemically important fund or bank gets over leveraged and pushed to the brink of failure, the Fed has your back.
Tech investors had already been luxuriating in excessive Fed liquidity. After briefly warning about “irrational exuberance” in December 1996, Greenspan returned to pushing down on the monetary accelerator. That largesse helped fuel the dot-com boom and bust. It also set the stage for the subprime debt mania that ultimately undid Lehman.
This is the same mistake Xi’s China may be making as the Evergrande saga unfolds. Again, no one can say what markets will think about conditions surrounding the world’s most indebted property developer. Or how international investors will feel about the default dramas to come—at Evergrande and elsewhere. But avoiding the worst-case scenario this month doesn’t mean China isn’t destined for the “Minsky moment” markets have long feared.
This is when an easy-credit-fueled boom ends badly. It happens to all industrializing economy, without fail: Latin America in the 1980s; Japan in 1990; Mexico in 1994; Southeast Asia in 1997; Russia in 1998; the dot-com crash of the early 2000s; Lehman Brothers and the broader U.S. in 2008; the “taper tantrum” in emerging markets in 2013. Really, no one beats financial fate and, odd are, neither will China.
What makes Evergrande so worrisome is the microcosm it represents. Real estate is the sector that’s most pivotal to Beijing’s periodic efforts to pump up gross domestic product via monetary stimulus and regulatory inducements. Time and time again, boosting property worked wonders to get GDP above 6%.
At some point, though, all engines lose thrust—or overheat. Evergrande, the central cog in China’s growth driver, is flashing red at the worst possible moment for Beijing. Beijing’s much-hyped “V-shaped” rebound from Covid-19 isn’t happening. Not only is China suffering new waves of infection, but recoveries in the U.S., Europe and Japan are disappointing across the board.
By avoiding a messy reckoning with Evergrande, China isn’t learning a lesson it needs to internalize to avoid a bigger one later on. If only the Greenspan Fed hadn’t shielded hedge funds like LTCM so energetically from turbulence, Wall Street might not have gone so wild betting on subprime debt.
Likewise, the message China’s property developers get from this moment is that global markets can stomach even bigger defaults down the road. Granted, it’s not clear how much Xi’s government is doing behind the scenes to paper over the Evergrande mess. But the signals from the People’s Bank of China are that a Lehman-like disaster won’t be tolerated.
And yet, by not learning the lessons from the late 1990s, China could be making a Lehman moment inevitable. And setting itself up for a bigger and more spectacular reckoning than ever needed to be the case. And thanks to Beijing’s ill-advised moves to make China’s economy even more opaque, that moment could easily sneak up on global markets.
This is the story China’s leaders wants to hide, but they can’t hide it indefinitely.
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