This week, Kaisa, a former poster child of China's booming real estate market, made history by becoming the first Chinese developer to renege on dollar loans. The immediate causes of Kaisa's default are clear enough: plunging property values left it with excessive debt. But it's still too early to know what Kaisa's failure will mean for China. Chinese President Xi Jinping must decide whether he is more interested in stoking short-term growth, or curbing the excesses that imperil the country's future.
On the one hand, Xi's government claims "market forces" will play a "decisive" role as it shifts to a growth model more reliant on domestic demand than exports and investment. Even Deng Xiaoping, China's first Communist leader to embrace free markets, never went so far in his rhetoric. And Xi's handling of major economic players like Kaisa and state-owned power-transformer manufacturer Baoding Tianwei Group, which defaulted this week on an onshore bond, has signaled his seriousness.
But for all of Xi's talk about market forces, he has also allowed the state to get even more deeply involved in the economy. Many observers see this week's move by the People's Bank of China to cut bank reserve requirements by 1 percentage point as a sign that the government's top priority is to prop up GDP. That's on top of the help that local governments recently received in refinancing debt, which essentially amounted to a stealth bailout from Beijing.
It's understandable that Xi would want to mitigate the turbulence and potential embarrassments associated with allowing China's credit bubble to burst. China is attempting a macroeconomic shift unprecedented in size and scale, at a time when all of its missteps will be chronicled by the international media. But China can't build a healthy economy unless it develops the stomach for letting companies and banks fail. Last week, Standard & Poor’s expressed concerns about the faltering profitability of Chinese companies and warned "more defaults cannot be ruled out." But it's still unclear whether Beijing will allow these failures to occur.
The defaults and bankruptcies to come could be on a far larger scale than we've seen this week. Kaisa's default on a $52 million loan is peanuts in the context of a Chinese economy where credit has exploded by $20 trillion since the 2008 global financial crisis. But Kaisa's situation underscores one of the biggest problems hampering Beijing: a lack of transparency throughout the economy. It was only in February that Kaisa admitted to having more than $10 billion in debt, far more than it had previously claimed. It's hard for policy makers to respond to the risks in an economy when they don't know where the cracks lie and how big they are.
Ideally, Beijing would match pro-growth policies with steps to empower market forces to police a shadowy financial system. But the government and central bank have instead been cooperating in swapping currency reserves for stakes in state-owned banks. The goal of that policy seems to be to boost lending, despite the obvious dangers of creating new asset bubbles.
"The authorities are conflicted," economist George Magnus of UBS told Bloomberg News. "They want to tame credit and reform the economy but their actions suggest that they are unwilling to preside over a period of slow growth and difficult reform."
If anyone understands the perils of letting companies fail, it's Henry Paulson. It was on his watch as U.S. Treasury secretary in 2008 that Washington opted to help Bear Stearns and let Lehman Brothers fail, to disastrous effect. But, in his new book "Dealing with China," Paulson argues that America's economic reckoning offers a timely window into Beijing's. "If the government is to discourage bad behavior on the part of market participants counting on a government bailout," Paulson writes, "it is crucial to decide clearly and decisively which institutions are systemically important and need to be supported and which creditors and investors should share in the losses."
He's right. Unless China combines stimulus with measures to punish bad behavior, today's stimulus will only set the stage for tomorrow's multi-trillion-dollar crises. Kaisa's reckoning is a chance to get the mix right. Xi shouldn't let the opportunity pass him by.
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