China, Lehman's, and the end of history

“How did you go bankrupt?” Bill asked.

“Two ways,” Mike said. “Gradually and then suddenly.”

(The sun also rises – Ernest Hemingway)

In 1990, China was the 8th largest economy in the world with GDP per capita in the hundreds of dollars and a non-existent middle class. Farming and metal bashing were core activities. Around a quarter of the population lived in cities. Fast forward to today and China is close to the world’s largest economy. GDP per capita has surged to around $10,000 and close to two-thirds of her population live in cities. The middle class now accounts for c.40% of the population. There has simply never been anything like it.

Previous ideas about democracy being a necessary precursor to strong economic growth, or even an inevitable bi-product of a certain level of per capita wealth[i] have been trounced along the way. The economic development handbook has been substantially rewritten.

Perhaps this helps to explains the gleeful schadenfreude that beams from much of the commentary on the economy’s recent struggles. The idea that China’s rise can only go hand in hand with Western decline is the implication. This week, we explore the rise and fall of Evergrande and what this means for China and the rest of us.

Evergrande – a politically connected property behemoth

Over the course of the last few months, a deliberately less forgiving backdrop from Chinese authorities has seen the world’s most indebted real estate developer[iii] begin to splutter. Many have wondered whether this is China’s Lehman’s moment – a financial sector butterfly flapping its wings creating a tornado of wider economic carnage both within the economy and beyond. Part of the problem here is the perceived nature of much lending within the Chinese economy. To some China watchers, Evergrande demonstrates the importance of political connections in the ability to amass vast quantities of debt.

Is this China’s Lehman’s?

The differences to Lehman’s destructive demise are more instructive than the similarities. Lehman’s was a large investment bank intricately intertwined into the global financial system. Evergrande’s exposures are large, complex, and still to be fully discerned. However, it operates within a still largely closed financial system (meaning the presence of foreign and independent creditors is very limited). Chinese authorities are sufficiently resourced and incentivised to relatively quickly mop up immediate contagion risks.

Lehman’s, in essence, began as a solvency issue, but very quickly (and devastatingly) morphed into a liquidity problem as other banks ceased to believe both in Lehman and each other. As Figure 1 demonstrates, evaporating confidence led to a choke in interbank markets, rapidly followed by a massive global economic heart attack, the many consequences of which we still live with today. Figure 1 also shows China interbank rates remaining so far calm.

It is also worth noting that many have been predicting Evergrande’s demise for a long time. Evergrande’s credit rating already was considered part of the ‘junk’ universe of firms – those deemed to be less creditworthy than their ‘investment grade’ peers. In fact, it was only back in April earlier this year that it failed China’s recently imposed ‘Three Red Line’ tests, which are key metrics imposed by policymakers specifically designed to curb leverage and systemic risk from over indebted companies. With its debt now already at distressed levels, the shock and awe of imminent default is already widely known and accepted. In contrast, Lehman was rated single-A (one of the highest ratings a firm can receive) and some ratings agency even reaffirmed their view Lehman wouldn’t fail the Friday before it filed for bankruptcy.[iv]

There are nonetheless significant, and likely economically painful, challenges ahead for China. Staunching contagion is one thing, however managing the resulting widespread financial distress is likely significantly more complex. To what extent should investors, stakeholders, and others bear losses is always the challenge in situations. The answer will inform future behaviour and risk taking amongst private actors. The long shadow cast by next year’s 20th Communist Party Congress, where President Xi is expected to break with decades of precedent and stay on in his role, will likely have a bearing on all of this too. All of this, amidst an economy heading towards a necessarily lower trend growth rate. Tight rope walking might look simple by comparison.

Is this China’s century?

We’ve long leaned against the idea that China is inevitably and imminently destined for a period of global hegemony. The recipe for both China’s miraculous economic success these last three decades and the best path ahead remain hotly debated. Many in the West have emphasised the capitalist ingredients (see the debate on the role of town and village enterprises) and thus fret over the apparent reversion to statism that many argue characterises President Xi’s second term. For others, China’s massive internal market and increasingly educated middle class (now producing over three million engineering graduates a year!) are just some of the factors that make China hard to bet against for the next decade. China’s performance during this latest crisis has further burnished the appeal of its model in many eyes, particularly when set against the challenges experienced by other nations faced with the same problem.

The lessons from history here are complicated (as always). The institutional model birthed in Europe in the wake of the enlightenment and forged in the fires of the first industrial revolution is designed to protect us from the fallibility of the individual. Similarly, in investing, we devote much of our energy to diversifying beyond the individual company in order to tether our future financial prospects more reliably.

No one would argue that that democracy is capable of delivering the best leaders time after time, but it has mostly proved to be a good way of getting rid of bad ones. Meanwhile, this crisis has dramatically, and perhaps to some extent permanently, changed the role of the state in many developed world countries this last year. However, some worry, with regards to China, about the degree to which Communist Party ideology pervades even corporate decision-making. Could that influence get in the way of a key strut of the productivity story – learning by doing????

China as an investment

Emerging market equites and debt are an important part of our asset class mix and China is impossible to ignore within that. We do not have any direct exposure to Evergrande debt or equity in our multi-asset class funds and portfolios nonetheless, testament again to our in house due diligence efforts. Our emerging market debt exposure primarily covers sovereigns (both hard currency and local) as well as quasi-sovereigns (often state-owned or state-backed companies). At the country level, we would reiterate that part of the point about global diversification is a necessary humility about the future, both near and far. We simply cannot know from our current vantage point whether in China’s evolution we are witnessing the creation of a new model for growth through middle income status and beyond.

However, the diversified exposure that our various teams of experts painstakingly install in our multi-asset class funds and portfolios is part of the protection against the idiosyncratic risks represented by the governance structure of one country or other. The high quality due diligence efforts of our teams looking at how to populate those exposures is another line of defence that has again proved itself invaluable here. We will continue to update you as the situation develops. However, we retain our view that the long-term prospects for the world economy remain worth betting on with as much of your savings as you can reasonably spare.

[i] Lipset, SM, (1959), Some Social Requisites of Democracy: Economic Development and Political Legitimacy, The American Political Science Review, Vol. 53, No. 1. (Mar., 1959), pp. 69-105.

[ii] Odd Lots, Bloomberg Finance talk – Understanding Evergrande, the Chinese Real Estate Conglomerate that’s nearing collapse (20th September, 2021)

[iii] Michael Pettis, What Does Evergrande Meltdown Mean for China? Carnegie Endowment for International Peace, Sept 20, 2021

[iv] Lehman not expected to fail, S&P analyst says – Reuters (12th September 2008)

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