China’s Bear Stearns Moment

March 19, 2014 Updated: March 19, 2014

In the end, it’s just going to be a few hundred million in write-offs. But the second imminent default of a Chinese corporate bond shows that China has passed its “subprime” moment and is staring into the face of a bankrupt debt juggernaut.

It was only last week that Chinese Premier Li Keqiang told the world that defaults on private company bonds and packaged investment products called trusts are “unavoidable.”

After years of unchecked credit growth and misallocation of resources, they indeed are. What Li didn’t tell us is: They cannot be centrally planned.

Chaori Solar Energy Science & Technology, a Chinese maker of solar cells, defaulted on an interest payment March 7, the first default of its kind in China’s recent history. The amount was small ($14.6 million), and yet this incident could well have been China’s Bear Stearns moment.

Despite the magnitude of one of the bulge bracket firms going bust in the beginning of 2008, most people did not think it would lead to a financial crisis of epic proportions, with serial defaults and subsequent bailouts.

Most people don’t think the paltry default of Chaori and the now imminent default of developer Zhejiang Xingrun Real Estate Co., which owes $566.6 million, will bring down the second-largest economy in the world. China’s mighty central planners will manage the coming defaults, subdue speculation, and re-price risk without a market slow-down in growth, or so the thinking goes.

China’s Debt Monster

If China really pulls it off, it will be the first country in history to pull the rabbit out of the hat. China has built up a debt bubble of epic proportions and there is not one instance in which economies managed to unwind that credit without serious shocks.

Yes, the central government is in good shape and has relatively little debt (45 percent of GDP in 2012). However, corporate debt exceeds 150 percent of GDP, the highest percentage in the world.

As for bank assets, they stand at a staggering $25 trillion, or 265 percent of GDP. While bank “assets” sounds great, the intricacies of double-entry bookkeeping show a liability for every asset. And since most of the bank assets are effectively owned by the central government, the central government is liable for this 265 percent of GDP in debt.

No harm done, if the assets are of good quality, right? And that’s exactly the problem. They are not. While official bad loans only stand at $95.8 billion as of 2013, they are up 48 percent since 2011.

As for claims on collateral, the coming default of a shadow-banking vehicle called Magic provides some real-life evidence what happens when the house of cards actually collapses.

According to Chinese media reports, the property developer in Chongqing will likely default on $32 million of debt on March 31.

The trust company that arranged the loan tried to get its hands on the collateral (an office building in the city) but could not, for reasons unthinkable in the Western world: Magic had already sold the building and mortgaged it to more than one other party.

So as more loans go bad and more companies start defaulting, the Chinese legal system will face insurmountable problems, prompting everybody to head for the exits at the same time. As with subprime, the outcome will not be pretty.