Could Evergrande turn into “China's Lehman Brothers”?

Evergrande is at risk of default.

It seems that there’s a number of comparisons being made between events now and some periods in the past. For instance, on a global level, comparisons with the 1970s are being made given things like supply strains and soaring inflation. Another comparison is being made with 2008; this time asking the question of whether Evergrande’s difficulties in China represent another ‘Lehman moment’.

When these comparisons are made, it could be said that history is a good guide to the past. Major nations like the UK and US, for instance, are not going back to the 10%-plus inflation rates that we saw in the 1970s and Evergrande won’t be allowed to fail in the same way Lehman was thirteen years ago. But, of course, we don’t need to see exact replicas of these events to spook asset prices and, on many levels the comparisons seem quite eerie.

On the first, we can certainly understand why many in the UK think that the country could be returning to the 1970s. For a start, there’s been a hugely adverse supply shock. In the 70’s, it related to oil price surges, while today it’s all about Covid-19. The resultant supply pressures have lifted inflation quite sharply and there’s even been talk in the UK of reduced workweeks because of potential energy supply problems to do with natural gas. The 1970s saw the infamous three-day week as the government attempted to conserve energy, helping to make much of the decade a very problematic one indeed. To cope with surging inflation, bank rates were pushed up to 17%, crimping growth and so leading to a new economic term; stagflation.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy said that he does not expect this to return now and, besides, a longer-term look at bank rates going right back to the 18th century shows that such high inflation and base rates were very unusual. It is more common to see low inflation and low rates. This being said, rates are abnormally low right now at just 0.1%. And, while nobody is suggesting that rates will have to back anywhere near 1970s levels, even a moderate overshoot of rate hikes relative to expectations could spook UK markets and we could see a similar thing if this were replicated internationally. When we look at the short sterling futures curve, for instance, we see that implied rates are expected to climb to only just over 1% over the next five years. In our view, even if we see a tiny repeat of the 1970s in terms of rising prices and supply tensions, rates will surely rise by more than this.

With Evergrande, the highly indebted Chinese property developer, it seems as if some sort of official support will occur, so avoiding a Lehman-like moment from 2008. But just as talked about above, even a Lehman-lite event could still be problematic. This is not least because the property sector in China accounts for an outsized amount of GDP; close to 30% on some estimates. House prices remain very elevated relative to income in international terms and investors hold up to a quarter of the housing stock, with much of the property empty. "While policymakers presumably won’t want to risk a full-blown Lehman moment by letting the company collapse without any support, their underlying desire to wean the Chinese economy off its debt habit suggests that some pain is not just likely for creditors, but desirable. Striking the right balance here is going to be crucial. Too much pain and a Lehman moment could happen; too little and the moral hazard issue stays alive with creditors convinced that such key companies are too big to fail. Whatever happens it could be a testing time; just as comparisons with the 70s in the UK and beyond will challenge investors as they fret about a new inflationary paradigm" Mr. Steve Barrow said.