Look in Japan for lessons on Evergrande

Updates from the Evergrande real estate group

Is the Evergrande saga akin to the bankruptcy of Lehman Brothers in 2008? Or is AIG’s rescue that year a better parallel? Or the Long-term Capital Management bailout in 1998?

It’s a question raised by investors as China’s second-largest real estate group struggles under the weight of more than $ 300 billion in debt (including $ 20 billion in dollar-denominated bonds) and a market domestic real estate that cools down.

But for my money, there is another historical parallel to ponder: Hokkaido Takushoku, the Japanese regional bank, which imploded 24 years ago when more than a tenth of its $ 75 billion loan portfolio suffered. turned.

At first glance, this comparison may seem strange. Evergrande is a real estate developer, not a lender. But what connects them is a question that haunted Japan in 1997 and now hangs over Chinese finance: namely, what is the pillar of faith upon which asset values ​​rest? Is it government support? Or is it the independent review of accounts by investors? Do either of the pillars work?

To understand why this is important, consider a Japanese story in a jar. In the mid-20th century after World War II, the Japanese government ordered its banks to funnel the country’s savings to favored industries at subsidized rates as it sought to rebuild the country’s economy. The strategy worked and the gross domestic product skyrocketed.

But then the maturing economy overtook this banking-centric system, as a child grows too big for a pair of shoes. Japan therefore imported certain structures of the western capital market. There has never been enough accounting transparency or true corporate independence for investors to determine whether a bank (or real estate company) is worth what its corporate accounts suggest. But it was always assumed that they wouldn’t fail if they were backed by the government and the corporate family, or “keiretsu», To which they belonged.

So when a housing bubble burst in the early 1990s, sparking widespread suspicion that the system was loaded with bad debt, investors didn’t initially panic – or not when they trusted the pillar of government. to support asset prices. But that collapsed when the Bank of Japan said in 1997 that it had “become impossible for [Hokkaido Takushoku] to meet its overall financing needs ”. And since corporate accounts did not offer an alternate pillar of faith, trust evaporated.

There are potential echoes of this story in China, which has also used a bank-centric, government-controlled financial system to foster rapid growth. As its economy grew and matured, it grew too large for this model of financial development and imported elements of a capital market system, such as stock markets, reports from company and rating agencies.

But fluctuations in house prices and poorly allocated loans to government projects have created a mountain of bad debt. The People’s Bank of China has made repeated, and sometimes heroic, efforts to clean them up, toughening up with entities such as Huarong, the country’s largest bad debt manager. But as corporate borrowing now accounts for 160 percent of GDP, there is (rightly) concern about the weaknesses of the system.

And while asset values ​​have been bolstered by this pillar of government support, it now looks like the PBoC wants to cut debt and sky-rocketing house prices with ‘three red lines’ of new regulatory caps – and make an example of Evergrande. . The result is that investors in China don’t know who or what to trust.

Maybe the PBoC will step in to restore this government pillar of faith? Markets rallied on Wednesday as Evergrande apparently found a way to avoid defaulting on its domestic bonds. He can also find a short-term solution to avoid defaulting on his dollar obligations. And the PBoC injected Rmb90 billion of liquidity into Chinese markets on Wednesday, apparently to reduce the risk of contagion.

However, even if an unpleasant crisis is avoided in the short term – and this remains a big ‘if’ – the longer term question is: does the PBoC really want to remove the pillar of faith of government that underpins it? the steps ? If it intends to do so, the question is whether corporate transparency can replace it.

Don’t bet on it. Today, investors can review recent stress tests of the PBoC and reports from rating agencies. They can also track individual entities at a level of detail unimaginable a decade ago in China (or Japan in the early 1990s). Indeed, one of the reasons Evergrande is struggling is that his own accounts showed he had passed the PBoC’s “three red lines” by some distance earlier this year. It is progress.

But while the transparency of Chinese companies is improving, it remains uneven. And, as the Hokkaido Takushoku case shows, when confidence in the pillar of government support is shattered, it takes a long time to restore or replace it. The 1997 financial shocks in Japan were followed by a long period of investor fear and deflation.

Chinese regulators have studied this story closely and want to avoid repeating it. But that’s an open question if they can. Hence the uncertainty over the true value of Evergrande bonds: is it less than 30 cents per dollar, as the markets suggest, or more? Place your “credit” bet – in the Latin sense of trust.

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