SCARE OF toxic debt is a pervasive feature of the Chinese economy. The latest concerns Evergrande, a struggling developer who threatens to cripple the real estate industry. The company also has tentacles that reach into the darkest recesses of China’s financial system, wrapping around banks and shadow lenders. Yet even as Evergrande attracts attention, another risk emerges: crony capitalism in small banks.
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A government crackdown on real estate leverage has pushed Evergrande to the brink of collapse. Other big developers are weighed down by $ 5 billion in debt. Speculation is swirling that one of them, Kaisa, is also struggling to make payments (he asked investors “for time and patience”). The turmoil can intensify as new debts fall due. According to Nomura, a Japanese bank, the real estate industry is due to repay $ 20 billion in offshore bonds in the first quarter of 2022, double the level this quarter.
Foreign investors quickly understood the risks. The yield on Chinese junk-dollar bonds hit a crippling 24%, excluding most issuers from the market. Some homebuyers are delaying their purchases, worried about handing over deposits to weak businesses. Construction has stalled in many of Evergrande’s 1,000 or more projects.
It is not known who is exposed to the losses and to what extent. Many developers are using shell companies, hiding their debts, while stock market regulators have allowed them to keep investors in the dark. On November 8, the Federal Reserve warned that China’s real estate problems were threatening the global economy.
Losses on home loans will hurt the banking system, but how much remains to be seen. But as we explain this week, lenders also face another danger. Crony capitalism flourished among the country’s small and medium-sized banks. Because the largest state lenders prefer to lend to other state enterprises, private companies and entrepreneurs have bought stakes in banks in the hope of gaining preferential access to credit.
While the banks involved are often small, they add to a giant problem. The Economist calculates that up to 20% of the commercial banking system may have close ties to tycoons or private companies. There have already been explosions. In 2019, the collapse of a small lender caused interbank lending rates to skyrocket; several other failures followed. Evergrande was until recently the owner of a captive bank in northeast China and is said to be under investigation for some 100 billion yuan ($ 15.7 billion) under deals with related parties.
For Xi Jinping, the Chinese leader, state control is the answer to both real estate and banking threats. To advance the projects, local communities take control of certain unfinished projects. In small banks, many private shareholders are driven out and replaced by asset managers from local communities.
This reveals the limits of Xi’s economic philosophy. The growing scope of state control can prevent a widespread panic, as it shows that almost all banks are underwritten by the government. But he fails to recognize an important truth about economics.
Many of the distortions plaguing Chinese markets have been created by rigid state control. In many private companies, insider relationships with lenders have been a way of dealing with a state-dominated banking system that discriminates against them. Xi may succeed in avoiding a sudden bad debt crisis by reasserting the authority of the state. But its reluctance to be bound by rules, to treat public and private companies equally and to offer predictability to investors will ensure that the financial system is doomed to suffer even more dangerous distortions in the future. â
This article appeared in the Leaders section of the print edition under the headline “China’s other debt problem”