Has China Reached its ‘Bear Stearns’ Moment?

In Shanghai on Friday, a solar energy equipment maker you’ve probably never heard of before, Chaori Solar Energy Science & Technology, couldn’t pay investors interest due on its bonds. In normal times, such an event might not get that much attention. But matters in China’s financial industry are far from normal these days. A dangerous build-up of debt and an explosion of risky and poorly regulated shadow banking have raised serious concerns about the health of China’s economy. That’s why the Chaori default — the first ever in China’s domestic corporate bond market — has sparked fears that the country could be headed for a full-blown economic crisis like the one that slammed Wall Street in 2008. “We believe that the market will have reached the Bear Stearns stage,” warned strategist David Cui and his team at Bank of America-Merrill Lynch in a report to investors.

The concern of Cui and others is that the Chaori default will be the tip-off point for an unravelling of China’s financial system. The default could wake investors and bankers to the realization that companies they thought were safe bets are potentially not, and they could begin to reassess other loans and investments to other corporations. In other words, they might start redefining what is and is not risky. That could then lead to a credit crunch, when nervous bankers become wary of lending money, or lending at affordable interest rates. More bankruptcies could result. That eventually causes the financial markets to lock up — and we end up transitioning from a Bear Stearns moment to a Lehman Brothers moment, when the financial sector melts down. “We think the chain reaction will probably start,” Cui wrote. “In the U.S., it took about a year to reach the Lehman stage when the market panicked … We assess that it may take less time in China.”

Such an outcome could be devastating to for China and ripple through the entire global economy. How likely is this scenario? Unfortunately, we can only tell what triggers a financial crisis after the trigger has been pulled. The general feeling among economists is that at least for now the default may not have a big impact. Chaori Solar, after all, is a much small firm than Bear Stearns was, and far less connected to other aspects of the economy.

But the Chaori incident could end up having a major effect on the way China’s financial sector works. Right now, your access to loans in China depends on who you are, not on how strong your business is. If you’re a state-owned enterprise, or a politically connected businessman, you can get credit whenever you want at low rates of interest. If you’re an ordinary entrepreneur or small private company, you’re stuck scrounging around for cash, often finding it only an exorbitant cost. That means money has been priced incorrectly and heads to the wrong people and companies. Making matters worse is a widespread perception among investors that the government or state-owned banks will always step in and prop up indebted borrowers (as they have in the past), further encouraging good money to flow to bad companies. All this has led to all sorts of problems — excess capacity, high levels of corporate debt and the emergence of alternative shadow banking on a giant scale.

For China to fix its financial system, and lay a strong foundation for future growth, money has to get allocated more intelligently — to good businesses that use it wisely. That transition is extremely difficult to achieve and is fraught with risks. Yet it is also inevitable if China is to reach a more advanced stage of development. The fact that the government did not step in and organize a bailout for Chaori is a signal that China’s leaders are willing to undertake this important transition. “Allowing Chaori to default will help correct the long-standing and recently growing assumption by investors that the Chinese government will not permit a default,” noted Brian Jackson, China economist at IHS Global Insight

Ultimately, then, we could look back at this default not as the trigger to a financial crisis, but a turning point when China started healing a very damaged economic system. The Chaori default could begin the process of changing the country’s financial system so money gets to the right companies and investments by encouraging more careful assessment of risk. Yet managing the process will be extremely tricky. China’s leaders must somehow allow bankruptcies and wean state enterprises off easy money, all without toppling the system into a crisis. We should all wish them luck.