China Faces a Reckoning With Evergrande Crisis. What Could Come Next.

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The debt troubles of property developer

China Evergrande Group

couldn’t come at a worse time for China’s already slowing economy. Global markets, too, may feel the ripples in the near term from a China-centric crisis. But there could be a silver lining: If Evergrande’s travails get too painful, Chinese authorities could offer investors a reprieve with targeted stimulus and possibly an easing of some recent investment restrictions.

China has been trying for years to grapple with the aggressive, debt-laden expansion of its property market, which has both bolstered the country’s economic growth and fostered problems. President Xi Jinping’s latest spate of regulations aimed at tackling inequality and curbing speculation has cracked down on debt. That has led to a reckoning for Evergrande (ticker: 3333.Hong Kong), which until recently was the largest developer in the world. Its $300 billion in debt has made it a poster child for the leverage problems that have worried China bears.

Beijing’s control of its economy, its ample reserves, and its unique toolbox limit the possibility of a 2008 Lehman Brothers-like contagion. Most analysts expect China to let Evergrande fail in a managed way, with authorities likely protecting the Chinese households who pre-bought Evergrande properties by making sure that housing is built, and shielding some onshore borrowers while allowing others to feel enough pain to help finally reform the property sector.

Indeed, The Wall Street Journal reported on Thursday that global investors holding Evergrande dollar debt, with a face value of more than $2 billion, didn’t receive interest payments that were due that day.

Beijing is preparing local governments for a “possible storm” from Evergrande’s demise and telling them to find ways to minimize the hit, such as limiting job losses, the Journal also reported this past week.

While Federal Reserve Chairman Jerome Powell on Wednesday said there’s little direct U.S. exposure to Evergrande debt, he noted the possibility that the fallout could impact global credit conditions by affecting confidence. A broad-based regulatory drive that has targeted China’s biggest companies and shifted the focus to social good over profitability has already rattled investors worried about the state taking a heavier hand in its version of capitalism. Those fears have contributed to the 19% decline in the

iShares MSCI China
exchange-traded fund (MCHI) in the past six months.

The losses that foreign holders of roughly $20 billion in Evergrande obligations could incur might add to concerns that China has become uninvestable, says Gavekal Research analyst Udith Sikand. That could trigger outflows from that nation and emerging markets more broadly—an exodus that would be especially dangerous for countries more reliant on foreign investors than China. In turn, that might lead to losses in emerging- market debt, which many investors have sought for yield. The

iShares J.P. Morgan EM Corporate Bond
ETF (CEMB) is down a half-percent this month, to $52.15.

Of more concern is the impact that Evergrande’s failure might have on China’s slowing economy. The property sector accounts for more than a quarter of economic activity and is a major source of wealth for Chinese households. A decline in property prices would hurt consumer confidence and exacerbate China’s slowdown—a major risk that analysts are watching out for.

“The problem is not just a single lender; it’s the whole Chinese growth model that is so dependent on producing real estate,” says Harvard University economist Kenneth Rogoff. “It’s not a Lehman moment in that they get a financial crisis, but it could be just as painful if you look at the longer-term growth.”

A deeper slowdown in the world’s second-largest economy would create its own tremors, hitting commodities as China’s construction activity contracts. It could also hurt industrials and even consumer companies that rely on Chinese customers, who could become too skittish to spend.

With the S&P 500 sitting on a 18% gain this year and investors antsy about anything that could spoil the run, China could be a spark for volatility, warns Jean Boivin, head of the BlackRock Investment Institute.

Clarity from Beijing’s authorities on how they will manage the fallout will be crucial in influencing how markets react, says Teresa Kong, head of fixed income for Matthews Asia. If issuance in China’s investment-grade bond market freezes up or credit spreads widen dramatically, it would signal that the situation is spinning out of control.

But Xi’s focus on avoiding social unrest and maintaining stability ahead of next year’s Communist Party Congress—when he is expected to push for a third term as president—adds to the urgency for authorities to contain the economic fallout.

China has already started some measured and targeted monetary and fiscal easing—the People’s Bank of China injected $17 billion into the banking system after earlier putting in $13 billion. Based on just how painful the unwinding could be, money managers say that the authorities could even ease their recent regulatory drive.

Boivin, who has been neutral on Chinese stocks amid the crackdown, says that such a pivot could invite investors with at least a six-to-12-month view to take a closer look at whether the shares offer a buying opportunity.

The next couple of weeks, however, could be dicey, as investors assess how Beijing navigates the problems in a crucial sector of its economy at an inopportune time.

Write to Reshma Kapadia at reshma.kapadia@barrons.com