Economist Writing Every Day

Nearly a year ago, on this blog we described the sequence of events that led to the Great Recession ( or “Global Financial Crisis”) of 2008-2009. The underlying problem was real estate-related debt: as inflated housing prices collapsed, many people couldn’t (or wouldn’t) pay their mortgages. Various financial dominos fell, but the one that gets singled out as the single most critical event was  the collapse of Lehman Brothers investment bank on September 15, 2008. The Dow Industrial average fell 504 points that day, and loss of confidence in the financial markets led to a freeze-up in credit, which was/is the lifeblood of business.

The likely bankruptcy of the gigantic Chinese real estate conglomerate Evergrande is being discussed as another possible “Lehman Moment”. It is hard to comprehend just how big this outfit is. It owns more than 1,300 real estate projects across China, directly employs 200,000 people, and is indirectly sustains some 3.8 million jobs. It got that big by borrowing (including selling bonds) and spending enormous amounts of money. The problem now is that it seems like it cannot service its $300 billion debt. Once things like this start to go bad, they often get much worse, quickly. Other parties stop wanting to do business with you, and it all goes downhill. (A famous reply in Ernest Hemingway’s The Sun Also Rises to the question, “How do you go bankrupt?” was “Gradually, and then suddenly”). The market prices on Evergrande’s bonds indicate that the market expects bankruptcy, with bondholders getting only about 25 cents on the dollar.

If this collapse materializes fully, a lot of investors will lose a lot of money, a lot of suppliers of building materials to Evergrande will not get paid and may go broke, and a lot of real estate development in China will freeze up for the time being.  Goldman Sachs estimates a 1-4% hit to China’s GDP, which is huge, and would reverberate across the whole world.

Wall Street seems to have been ignoring this drama, until yesterday (Monday). Blam, stocks fell around 2%, and were still headed south at the end of trading. Is this the start of The Big One? Well, that makes for dramatic commentary, but most observers seem to take a more nuanced approach. First, the all-powerful Chinese government could order the People’s Bank of China to “fix this”. We all now know that central banks have magical powers to create as much money as needed to, e.g., buy all outstanding Evergrande bonds at near-par. On the other hand, the Chinese government lately has been clamping down on speculation. So there may be some sort of compromise, a semi-orderly unwinding, with bondholders feeling some pain, but actual real estate operations being sold off and continuing under some other names.

Wall Street may be more worried about whether the Fed announced on Wednesday that it will take away the punch bowl by tapering of its bond purchases. The last time the Fed did that, in 2018, stocks took a long and hard tumble. Again, a range of outcomes is possible here.

Ironically, all these concerns, as long as they don’t really turn into something serious, may be a bullish indicator for stocks. Stocks are said to “climb a wall of worry”; it is when everyone is totally complacent that is a setup for a crash. Time will tell whether the Evergrande difficulties end up being part of  a bullish wall or a bearish cliff.