Extra Credit: ‘A different kind of moral hazard’: The history and politics behind the Evergrande debt crisis

The history and politics behind Evergrande’s fallout

The saga of property developer China Evergrande Group
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has dominated financial news and markets this week. Of particular interest to investors and others is whether the Chinese government will let Evergrande collapse — and to what extent the company’s downfall will take the Chinese economy along with it. 

Evergrande’s large debt load — which it owes not only to traditional investors and banks, but also to homeowners who placed deposits on apartments that are at risk of never being built, suppliers and its own employees — is what’s put the company in such a tenuous position. 

The crisis has invited comparisons (and dismissal of the comparisons) to the fall of Lehman Brothers in the U.S. in 2008. That got me curious about the approach to corporate debt in China by the country’s companies and government and how it differs or is similar to the U.S. I called up Meg Rithmire, an associate professor at Harvard Business School, to learn more. 

Rithmire, who studies the relationship between capital and the state in China and elsewhere in Asia, explained that private enterprises having access to corporate debt is a relatively new phenomenon in China. For much of the country’s modern economic history, companies that weren’t owned by the state struggled to get access to credit from state-owned banks because their legal status was nebulous, she said. 

“Most of the investment in China in the 80s and 90s in these firms was from retained earnings or personal raising of funds,” Rithmire said. “In a weird way being cut out of the formal financial markets made a lot of these firms really disciplined.” 

By the early 2000s, the legal status of private companies in China became clearer as the country privatized portions of some state-owned enterprises, allowed entrepreneurs to join the Communist Party of China, and made other reforms. That meant that private firms could more easily access credit. But China’s political environment — the one party rule, the need for businesses to stay close to political leaders in order to be successful — allowed space for well-connected companies to take on a lot of debt the fiscal discipline that had once characterized the Chinese private sector, Rithmire said. 

“All of these firms basically had personal connections to people in power in China, they had this access to banks and to state banks to be able to borrow quite a bit of money,” she said. “That political and economic mismatch has generated a lot of corporate debt problems.” 

That nexus between government and business makes the moral hazard calculation different for Chinese firms and government officials than in other countries where business and government aren’t quite as close, Rithmire said. For example, critics of bailouts or the (relative) lack of prosecution of financial crimes here in the U.S. tend to worry that these kinds of behaviors encourage malfeasance because firms are sure they’ll be bailed out or avoid consequences for their actions. 

But in China, corporations know that any crackdown could also implicate the government, Rithmire said. “That’s a different kind of moral hazard, which is that it’s a political liability for the regime,” she said. “If you go down, what do you reveal about me?”  

Amid that dynamic, well-connected companies built up debt and used it for all sorts of purposes, like buying assets abroad and investing in sectors in which they have “no strategic capabilities,” Rithmire said. (Evergrande, for example, was involved in theme parks, electric vehicle production and other businesses). 

In interviews and discussions with some of these companies — though not Evergrande — as part of her research, Rithmire found that “one strategy that they were taking was their goal was to become too big to fail,” she said. “If you’re too big to fail the Chinese government can’t take you down, they have to live with you.”  

Last year, the Chinese government did attempt to curb borrowing by debt-laden property developers by instituting rules on the amount of leverage these companies could take on if they wanted to borrow more. The so-called “three red line” policy is part of what precipitated Evergrande’s downfall. The Wall Street Journal reported this week that Chinese officials told local governments to prepare for the possibility that Evergrande would collapse, indicating the government may be hesitant to bail the company out. 

These challenges with corporate debt are being sorted out almost in real time because companies have only had access to this kind of leverage for about 20 years, Rithmire said. “We think of the Chinese economy as very large and very sophisticated,” she said. But “these kinds of corporate debt crises that we’re seeing in China, all of this is new.”

How the government might respond is “all pretty unclear and ad hoc,” she added. 

Loan volume increased 450%, the workforce increased 6%

The largest consumer lender in the country has been chronically understaffed for more than a decade, even as its responsibilities dramatically increased during the same period.  

That’s one takeaway from a report published this week by the Government Accountability Office, a government watchdog. 

Between 2010 and 2019, the volume in Direct Loans — the government’s main student loan program — increased by 450% and the number of borrowers grew by nearly 150%. But staffing levels at the Office of Federal Student Aid, which oversees the government’s student loan portfolio, rose just 6% during the same period, the GAO found. 

Though many outside of the wonk set may find it hard to care about an audit of an obscure government agency’s workforce needs, there’s reason to care even if you don’t identify as a policy nerd. The GAO’s findings have implications for the millions of people with a federal student loan. 

Federal Student Aid handles a slew of tasks that are operationally complex and high stakes for borrowers. The agency hires and oversees student debt collectors, awards contracts to and manages the student loan servicers where borrowers send their payments, disburses federal financial aid dollars to schools, and more. 

Many factors, including high tuition costs, are contributing to the nation’s student loan challenge, but over the past several years, evidence has indicated that the experience of repaying student loans — one which FSA has a role in — is likely exacerbating the problem, as borrowers struggle to access the cheapest repayment plans available to them and the benefits they’re entitled to. Just this week, Politico reported that thousands of teachers had been rejected from a loan forgiveness program for public servants.  

“Some of the tools that exist to ensure that people have better access to protections, access to pathways to forgiveness just aren’t working as well as they could,” said Sarah Sattelmeyer, project director, education, opportunity and mobility at New America, a think tank. 

During the study period, Federal Student Aid’s responsibilities became more complex, but its staffing levels didn’t adjust, the report found. Between fiscal years 2011 and 2013, the agency implemented a new suite of payment plans that allow borrowers to pay back their debt as a percentage of their income and took up agreements with 20 student loan servicers, among other tasks, according to the GAO. But staffing levels didn’t increase. 

We’re once again in a period of growing responsibility for Federal Student Aid. Student loan payments and collections are set to resume in February, marking the first time the entire student loan system has been shut off and booted back up. Two servicers recently announced they wouldn’t be renewing their contracts with the government, which means about 10 million borrowers will be transitioning to new servicers — the main point of contact for borrowers managing their student loan bills. 

The Department of Education is also in the midst of reassessing many of the regulations surrounding student loan repayment, for-profit college oversight and other elements of the student loan program. FSA will likely be involved in implementing any major changes that come out of those discussions. 

“There’s a tremendous amount of pressure on an already taxed workforce,” Sattelmeyer said. 

The agency will be going into these efforts with more staff than in the past. Federal Student Aid increased its workforce by 17% last year and prioritized hiring in areas where there was critical need. That hiring came amid analyses by the agency on its workforce needs, skills gaps and other areas. Still, as of February 2021, the agency had a staffing gap of 705 full-time employees, according to the GAO. 

“I’m really glad that FSA is beginning to manage this chronic understaffing, but that won’t be solved or fixed overnight,” Sattelmeyer said. “There are outstanding concerns and things coming down the pike. Does FSA have a stop gap plan until staffing is dramatically increased?”

In a letter responding to the GAO report, Richard Cordray, the chief operating officer of Federal Student Aid, said the agency agrees with the GAO’s conclusions. In addition to the already completed workforce study, the agency plans to do follow-up work focused on making FSA’s processes more efficient, increasing collaboration, and other areas, Cordray wrote. FSA is also assessing staffing needs to align them with Cordray’s priorities, he wrote. 

“FSA continually strives to address its personnel needs and improve its hiring and staffing practices,” Cordray wrote. 

Debt-related odds and ends

• House Democrats passed a bill this week that would fund the government and raise the debt ceiling as deadlines loom to stave off a government shutdown and prevent the nation from defaulting on its borrowing obligations. The bill passed along party lines and likely faces an uphill battle in the divided Senate. Republican leaders have said Democrats will have to raise the debt ceiling on their own. (To learn more about the history of the debt ceiling, visit this previous Extra Credit column). 

• Debt held by households ticked up at a rate of 7.9% in the second quarter of 2021, compared to an increase of 6.7% in the previous quarter — the largest increase in household debt since before the 2008 financial crisis, Marketwatch’s Greg Robb and Rex Nutting write. The report is the latest indication that consumers may be taking on more debt as the impact of pandemic relief measures wanes. 

• Andrea Riquier takes a look at how localities in New York state use fines and fees for traffic violations and court appearances as a source of revenue and the disproportionate impact this practice has on people of color. “Police acting as armed debt collectors risk Black and Brown lives and extract wealth from New York’s poorest communities,” Fines and Fees Justice Center wrote in a report that was the subject of Riquier’s article.