Lessons from Evergrande and the US debt ceiling

3 min read
fairly difficult
The unwinding of China's most indebted real estate developer and US debt ceiling negotiations reveal the hard policy decisions linked to high borrowing levels.
Of course, this is little comfort for Evergrande bondholders who are likely to recover close to zero on their investment. With appropriate diversification, any losses at a total portfolio level should be manageable for most investors, but the point still stands – investors take a loss. Such an outcome should be front of mind when lending to, or investing in, highly leveraged companies.

As a policy framework for dealing with excess debt, this falls within the "tough love" category. The outcome is harsh, but arguably fair. Indeed, the Chinese authorities would welcome the increase in investor due diligence that an outcome like Evergrande creates.

Moral hazard

By imposing losses, the authorities hope to counter the moral hazard that arises when all investments, no matter how risky, are perceived as "money good". Over time, and with lessons learnt, markets will get better at pricing the risks that led to this outcome.

The lasting lesson is that large corporate debt burdens are best dealt with by imposing some degree of losses on bondholders.

But if an Evergrande wind-up becomes enshrined in future MBA case studies of how to successfully solve a debt problem, what does this mean for those other debt rhinos in the room, the large government debt burdens carried by the US and many other countries?


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