Writing for the Financial Times, Alan Beattie warns of a wave of defaults from developing countries around the world. The basic mechanisms causing the instability are inflation, rising interest rates in the developed world, and overall uncertainty about globalization due to geopolitical factors.
Creditor nations are not prepared for the fallout. Beattie writes:
There have been multiple attempts to regularise sovereign restructuring to achieve fair burden-sharing between creditors. The “London Club” of commercial banks was set up in 1976, when much sovereign borrowing was via bank loans, and was heavily used during the sovereign debt crises of the 1980s. But it hasn’t really been relevant after borrowing shifted to capital markets. For official creditors, the “Paris Club” was created in 1956 to address a debt crisis in — where else? — the serial defaulter Argentina.
The Paris Club played a key role in resolving episodes like the HIPC debt relief initiative, but has always struggled with compelling private sector creditors also to write down sovereign debt. Twenty years ago, the IMF heroically tried but failed to set up an official bankruptcy procedure (the sovereign debt restructuring mechanism) to bail in private investors.
Borrowers have increasingly added clauses to sovereign bond contracts to ease restructuring, but they have imperfect coverage and effectiveness. Sovereign bankruptcies with official bailouts and private creditors are still worked out ad hoc, sometimes with rival creditor committees. Resolution can get particularly protracted when litigious distressed debt investors get involved.
Making things worse, China is one of the dominant players. It isn’t part of the Paris Club and until now has not had to deal with a sovereign-debt crisis as a major lender. Paris Club countries ordinarily agree to forgive some of the debt when debtor nations default, in the interest of resolving the instability and getting the country back on its feet again. China so far has not taken that approach.
Just how big a player is China? Peter Hartcher of the Sydney Morning Herald writes that “China has more money on loan to the world’s poor countries than the combined lending of the 22 rich nations that make up the Paris Club of creditor countries.” He notes that “most of the world’s poor countries — 60 per cent of them — are now in debt distress or at high risk, according to the World Bank.”
If many of those countries go bust at the same time, the consequences for China would be significant. The Belt and Road Initiative (BRI), considered by some to be a genius geopolitical strategy, is a big part of the reason for China’s exposure to risky sovereign debt.
Reid Standish of RFE/RL writes:
The globe-spanning scale of BRI, which was launched in 2013 by Beijing as the largest infrastructure program undertaken by a single country, has left it with a list of risky debtors around the world — including Argentina, Pakistan, Russia, Tajikistan, Venezuela, Zambia, and Iran — that hoped to take advantage of the surge in Chinese overseas lending but now find themselves struggling with a debt crisis the World Bank has warned could trigger a series of defaults not seen since the 1980s.
For China, this marks what analysts describe as a crucial inflection point after nearly 10 years of runaway lending under the guise of the BRI that has been exacerbated recently by rising inflation, soaring energy costs, and tightening global financial conditions due to the war in Ukraine and the aftermath of the COVID-19 pandemic. In such an environment, Beijing could be looking to streamline and scale back its hallmark initiative.
Standish notes that China has lent almost $1 trillion under BRI in the past eight years. Pakistan is the largest recipient of BRI financing, and China has been lending it even more money to pay back its loans. Standish writes:
But tensions over the implementation of BRI projects has strained relations for both Beijing and Islamabad. Still, Beijing has issued a string of loans aimed at averting a default, with a consortium of Chinese state banks lending $2.3 billion to Pakistan in late June.
Beijing has reportedly urged Islamabad to repair ties with the IMF and resurrect a loan program agreed in 2019, of which the fund has so far given only about half of the agreed $6 billion sum.
Pakistani Finance Minister Miftah Ismail told Bloomberg on August 1 that progress had been made on the loan, which could stave off a default, but analysts say Islamabad’s finances remain strained, and Mingey said that Pakistan is still a leading “domino to fall” after Sri Lanka amid the debt crisis and possibility of further defaults.
On top of these foreign concerns, China’s domestic markets aren’t doing any better. The Times of India has an excellent explainer on the instability in China’s housing-dominated financial market, which begins with this sentence: “When the world’s most populous nation begins selling apartments for garlic and watermelons, you know something is wrong.”
Indeed, and the Chinese government is to blame. The Times of India says:
In the late 1990s, the Chinese government began leasing out land to developers, who began a building frenzy. The government encouraged this by offering easy financing options for real estate developers like Evergrande. These companies relied on cheap debt to acquire land parcels at scale. This created an artificial scarcity and rise in property prices.
In cities like Beijing and Shenzhen, real estate prices tallied up to more than 50 times the average national income. A working paper published by the National Bureau of Economic Research in 2020 estimated China’s real estate sector accounted for 29% of the country’s GDP ($4trn out of $14trn).
When prices rise so much, nobody wants to buy anymore — not speculators, not investors, and not even ordinary homebuyers. Real estate developers are now staring at a financial crisis, with the largest of them close to collapse.
How does the Chinese government plan to fix this problem it created? More intervention, of course. The government adopted a policy of “three red lines,” mandating that the largest real estate developers had have: 1) asset-to-liability ratios above 70 percent, 2) net-debt-to-equity ratios below 100 percent, and 3) cash-to-short-term-borrowing ratios below 1.
Instead of fixing the problem, the three red lines just hastened the market collapse, the Times of India says. In addition to the housing struggles, the economy is suffering from two other maladies that the World Bank says will slow GDP growth even further: “the country’s long crackdown against specific industries, such as fintech, online education and entertainment as well as perceived societal ills such as celebrity culture, gaming and effeminate fashion trends” and “the country’s rigid zero-Covid strategy that has led to stringent and extended lockdowns.”
Responsibility for each of those three problems lies with the Chinese government, the Chinese government, and the Chinese government, respectively.
The Times of India article concludes on this cheery note:
The government is scrambling to fix this and has asked banks to start lending to real estate firms, hoping this infusion of capital will help. But that could just be continuing the vicious cycle of debt and default that these companies are already in.
As more countries default on their debts, the developed world will feel the impact, but China is taking the most severe blow. China has been able to get away with a lot of poor decisions in a world of low interest rates; that world is gone now. Where the West at least has some processes and experience dealing with developing-world defaults, China has none and is dealing with its own crisis at home. Those who view China’s authoritarian structure as a strength because it allows the Chinese to “play the long game” better than a democracy should keep these government failures in mind.