The gigantic real estate developer Evergrande’s credit crisis is shaking world financial markets. Evergrande is China’s second-largest of its kind with massive 300 US$ bn outstanding debt. As reported by the press, the firm is struggling to pay interest on its liabilities, as it falls short of cash inflows from its assets. Investors are racing for the exit in a default scenario, causing Evergrande stock and bond prices to collapse. In turn, the sell-off has affected stock and bond markets on a worldwide scale. With good reason, because the “contagion issue” is real.
Evergrande’s debacle could herald the bursting of China’s housing bubble, which has been feared for years already. Perhaps it is not only Evergrande that has gotten into financial trouble, but other real estate developers as well? If and when this is the case, the ramifications for almost all industries can be expected to have far-reaching consequences. Not only would it cause a severe setback to the business cycle. The need to liquidate (or: fire-sell) construction projects could even trigger a drop in residential property prices. This, in turn, could all too easily result in painful loan defaults for banks.
In such a case, it is quite likely that the credit market will dry up, and all of a sudden many borrowers will find themselves in dire straits: trying to roll overtheir maturing debt, they will face significantly higher borrowing costs, or creditors may no longer be found to provide the urgently needed funding. As more and more debtors struggle to service their debt, the credit-driven boom turns into bust. The economist Murray Rothbard puts it succinctly. He wrote in 1973:
“Like the repeated doping of a horse, the boom is kept on its way and ahead of its inevitable comeuppance by repeated and accelerating doses of the stimulant of bank credit. It is only when bank credit expansion must finally stop or sharply slow down, either because the banks are getting shaky or because the public is getting restive at the continuing inflation, that retribution finally catches up with the boom. As soon as credit expansion stops, the piper must be paid, and the inevitable readjustments must liquidate the unsound over-investments of the boom and redirect the economy more toward consumer goods production. And, of course, the longer the boom is kept going, the greater the malinvestments that must be liquidated, and the more harrowing the readjustments that must be made.”
And that is what should actually be worrying investors: the danger that Evergrande’s credit crisis could be the starting point of a new worldwide credit crunch. The Evergrande debacle could serve as a reminder that the global economic and financial system is literally built on credit, fuelled by an enormous increase in credit since early 2020. Should investors become concerned about the quality of the outstanding debt and lose confidence in borrowers’ ability and willingness to service their debt, all hell would break loose. If and when the flow of credit dries up, consumption and investment will be hit hard, and financial asset prices are likely to decline sharply.
When the US-bank Lehman Brothers collapsed in September 2008, it led to a credit crunch that became the biggest financial and economic crisis since the “Great Depression” in 1929-33. The key question now is: Will China’s Communist Party (CCP) intervene and bail out Evergrande? On the one hand, the CCP wants to make the economy less credit-dependent, pushing for deleveraging the economy. On the other hand, deliberately allowing an Evergrande’ credit event with its incalculable contagion and ripple effects could backfire politically.
If the 2008/2009 and 2020 crises taught us anything, it is this: the storm of a credit crisis could all too easily turn into a hurricane that could bring the economy and financial markets to their knees; and that such a scenario would be inevitable without government intervention in the form of a rate cut by the central bank, an increase in the quantity of money, and underwriting credit risk. Against this backdrop, if the storm gets worse, it is reasonable to assume that the CCP will at some point step up and keep the worst – the hurricane – from happening.
While investors in stocks, bonds, and housing may find relief in such an outlook, the uncomfortable truth would be that inflationary policies will be intensified not only in the US and Europe but also in China. Any government-sponsored bail-out of a credit crisis would have to rely on a sizeable increase in the quantity of money, and an increase in the quantity of money will translate to higher goods prices, be it consumer, producer and/or asset prices. That said, the overleveraged economic and financial system is actually paving the way for rising price inflation.
It cannot be dismissed out of hand that Evergrande could become “China’s Lehman” moment. At the same time, such an unfortunate outcome could be averted, or at least contained, by an early and determined bail-out by the CCP firing up the electronic printing presses of the Peoples’ Bank of China. Either way, investors may want some protection against the risk that central banks worldwide will increasingly be taking recourse to inflation to fend off a crash of the credit pyramid they have been building up over the past decades.
Physical gold and silver come to mind. The exchange value power of these precious metals cannot be debased by monetary policy. And they also do not carry a default or counterparty risk. Especially for long-term oriented investors, holding physical gold and silver as part of their liquid portfolio should pay off, as, in the coming years they can be expected to be both risk-reducing and returnenhancing. The current Evergrande debacle may or may not be easily overcome. In any case, it should be seen as a kind of precursor of what the world’s creditdriven monetary system still has in store for us.
