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Markets are like life: sometimes you need a clean-up. This is when domestic disputes arise. Some of these result in separation; others are better managed.
The case of the French submarines contract with Australia is a perfect example of a badly managed dispute. The players have been at loggerheads for some time. Pacts have been broken and there has been no clean-up.
For an example of the opposite scenario – a well-managed clean-up – we need look no further than China’s handling of over-indebted players. There, the authorities face an excess of structural indebtedness. Indeed, the country’s total debt has risen from around 160% of GDP in 2008 to over 320% today. To clear this, or at least slow its expansion, the authorities tightened monetary conditions at the start of the 2010s. This balance sheet clean-up resulted in some difficult years for Chinese real estate, particularly in 2011 and 2014. On the back of this experience, China refined its monetary toolbox to steer a constant course between the economic stimulus necessary to the stability of the regime on the one hand, and managing any overheating from debt on the other. The COVID-19 crisis was the ideal opportunity to fully bring this expertise to bear. After stepping on the accelerator at the beginning of 2020 as the country suddenly ground to a halt, shortly thereafter Beijing cut back its stimulus measures, going as far as adopting a slightly restrictive line in the first half of 2021. This resulted in a lower growth rate in the second half of 2021, with over-indebted players coming under pressure.
The critical situation of real estate developer Evergrande is a prime example of this. A poor-quality player with a stretched financial structure, but the number two in the sector in China, it risks bankruptcy with systemic repercussions as conditions become less favourable. Yet here again, Beijing has taken deft action. Rather than a wholescale rescue of Evergrande, the government injected additional short-term liquidity into the system, thus avoiding a meltdown in the banking sector, and organising a restructuring of liabilities, made possible by the symbiosis of the public and private sectors in the country. Furthermore, it is likely that Beijing will decline to provide support for some other less systemically important players, or foreign banks which, despite the obvious weaknesses of the company, misguidedly purchased Evergrande debt. The clean-up will be complete, even if there are some casualties along the way. But the major domestic dispute between the middle classes and the authorities must be avoided. Chinese households need homes, or to receive the rental income that they are counting on. If not, would the regime be keeping its promise of “common prosperity”? The buildings must therefore be completed, “whatever the cost”. This is reassuring: although there may be some turmoil, the shockwave of restructuring should be absorbed. Evergrande is far from becoming a new Lehman Brothers. Even the US wouldn’t allow Lehman Brothers to fail today.
Over in the US, the clean-up of the Fed’s balance sheet has still not started. It is still purchasing USD 120 billion of bonds per month. But the shift is coming. The Fed Chair’s speech on 22 September leaves little room for doubt: unless the economic environment deteriorates unexpectedly, purchases should start to decline by the end of the year. Markets will then enter a new phase of progressive tightening. Interest rates should rise. And as in China, or anywhere in truth, the most indebted players will then be under pressure. There will be defaults. We will have to see if any of these represent a systemic risk, especially after such a sharp rise in real estate prices, where some will have gone overboard. But as the Fed has also learned, the system cannot countenance a domestic dispute with households. Liquidity will again be injected if necessary, and without limits.
In truth, there is no alternative. Given the level of indebtedness that the world has reached, the only solution to debt, apart from moderate inflation, is the creation of new debt. This is before taking into account any imminent new expenditure commitments for which estimates are still hazy. The COP 26 climate conference to be held in November will provide a reminder that ultimately, emergency expenditure would be far more costly than taking on debt today to combat global warming . The final balance sheet clean-up can wait – households cannot.
Written on 24 September 2021, Alexis Bienvenu, Fund Manager, LFDE