Insights

Evergrande & Crypto - Bigger Picture

Dr. Joseph Chen-Yu Wang

Big news this week is the financial trouble of the Chinese real estate developer Evergrande. As it turns out, the financial problems of Evergrande are connected with Chinese regulation of Bitcoin and other cryptocurrencies, over the last decade. Sounds too far-fetched? Let’s dive into details.

EVERGRANDE AND LEHMAN - SIMILARITIES AND DIFFERENCES

Whenever people mention Evergrande, they immediately bring up the collapse of Lehman Brothers in 2008. History however never completely repeats because once something happens, people are affected by it, which subsequently affects actions that people take in the future. Over the last decade, the Chinese government had a chance to analyze what happened with Lehman and learn how to prevent history from repeating. Although this might not be obvious, this effort has largely influenced cryptocurrency regulation in China.

Let’s start with one basic similarity between Evergrande and Lehman, the role of the business cycle. Market economies are inherently unstable and subject to boom and bust cycles. The troubles at Lehman started with the dot-com bust in 2001. Because at the time global economy was in recession, the Federal Reserve pumped a large amount of money into the system. Once money enters the financial system, companies naturally borrow this money, as interest rates become lower, so that they can make more money. In the end, as more easing is done, the more companies borrow, and invest in their business, or sometimes questionable things. At some point such a bubble led by lowering of rates and liquidity injections pops, and things start to fall apart. When this happened in 2008, the financial system imploded, and took quite a bit of time to recover.

There are two basic strategies to avoid such a disaster. One is to not pump money into the economy in the first place, or austerity, but it carries its own problems. Europe tried this, and it led to levels of unemployment that would have been unacceptable in China. Consequently from 2008 to 2012, the Chinese government injected massive amounts of credit into the economy and at the same time tried to structure the financial system so that when the inevitable crash happens, it would be a controlled wind-down and not a disorderly disaster like Lehman.

WHY BANKS ARE DANGEROUS

One thing that caused Lehman to be such a disaster was that it was a bank. A bank is a place where money can be placed via repurchase agreements (REPO), which are a form of short-term lending for dealers, with the expectation that it can be repaid quickly. Banks conduct trading with other banks, but they frequently net balances and are very careful when it comes to extending credit risk, thus whenever there is a crisis, everyone starts to pull money out of banks, and cut credit lines. What's more, when a bank fails, people that expected to have ready access to cash find that their funds have disappeared, or would end up in a liquidation process, causing panic that can feed on itself.

What the Chinese government has done for the last decade is try to keep the different parts of the Chinese economy separate so that when a real estate company such as Evergrande fails, it doesn't spill over into the banking system. At the same time, the Chinese government has tried to prevent something that doesn't look like a bank from becoming a bank. One of the slogans that you will often hear in cryptocurrencies is that Bitcoin lets you set up your own bank. That is explicitly what the Chinese government is worried about.  They want to carefully regulate banks to make sure that they are managing their money wisely. Cryptocurrencies allow anyone, including Evergrande, to create their own banks, which could create a disaster in a time of a crisis.

CHINESE POLICY TOWARD CRYPTOCURRENCIES

Over the last decade, the Chinese government has tried to set up rules such that when a real estate company like Evergrande runs into trouble, it does not take down the rest of the economy. A lot of this involves putting barriers in place so that a crash in one part of the economy does not spread to other parts of the economy, ensuring that any economic problems do not spread, and also putting rules in place so that cryptocurrency is not used to create unregulated shadow banks.

Because the whole point of cryptocurrencies is to make it easier to connect different parts of the economy, the Chinese government is concerned that cryptocurrencies would cause problems in one part of the Chinese economy to spread very quickly and uncontrollably to other parts of the economy. The restrictions that the Chinese government has placed on cryptocurrencies have been to prevent this from happening. The first restrictions in 2013 prohibited banks from undertaking cryptocurrencies businesses, and this was out of fear that a crash in cryptocurrencies would cause banks to lose depositor money. These have been followed by restrictions on the use of cryptocurrency for payments and restrictions on its use in payment platforms.

One of the most significant actions took place in 2017 when the Chinese government closed down domestic exchanges and allowed only P2P trading. This occurred because the exchanges had large pools of depositor fiat currency that were available to invest. Because depositors can withdraw fiat at any time, this created a de facto bank that could have caused financial issues in a crisis. Since exchanges custody client cash, if they invest that pool of money into things such as real estate, they could end up in a situation such as Evergrande.

EVERGRANDE AND RECENT MOVES TOWARD CRYPTOCURRENCIES

Over the last year, the Chinese government concluded that the rest of the Chinese economy was strong enough to withstand the collapse of heavily indebted real estate companies. Therefore, over the previous year, they put restrictions limiting loans available to indebted companies, mounting further financial pressure on heavily indebted companies.

At the same time, the government has introduced new restrictions on cryptocurrencies, and these restrictions were set up in part to reduce risk in the financial system. Restrictions on crypto imposed in mid-2021, were to prevent people from gambling on cryptocurrency, as an alternative to newly restricted lending to property companies. However, as the government became more focused on real estate companies, and as it has become apparent that cryptocurrencies are not adding risk to the economy, the government is now reducing restrictions on cryptocurrencies.

IMPLICATIONS FOR CRYPTOCURRENCIES

In the short term, the Chinese government's actions regarding Evergrande and other real estate companies will likely cause a lot of volatility in the crypto markets. Moreover, as the government tightens and untightens policy, money can move in and out of crypto rapidly and unexpectedly, leading to extreme price volatility.

Long term, these actions are likely to be net positive for crypto. Restrictions on indebted developers will cause downfall of the unhealthy ones and will eventually lead to a more healthy Chinese economy. Having finished dealing with the real estate bubble, the government will likely restrict money from blowing up real estate again, and this money might flow into cryptocurrency.

FAQ

What is the most common misunderstanding of the Chinese government?

A lot of analysis of the Chinese government does not look at the big picture. Every time the Chinese government has restricted cryptocurrencies, it did so because it is worried about systemic risks to the Chinese economy. In trying to understand government policy toward Bitcoin, one has to look at the significant issues that worry the government. One characteristic of the Chinese cryptocurrency and blockchain environment is that everyone knows who the people managing the exchanges are, but it is not very transparent who actually owns the mines or exchanges. The Chinese government is worried that large companies like Evergrande could borrow money and bet on cryptocurrencies or mining, which could lead to a financial disaster.

What are the Chinese government's goals in regulating cryptocurrencies?

For much of the last decade, the Chinese government has been trying to figure out how to regulate crypto, and it has had two significant concerns. The first is the use of cryptocurrency to move money out of China. The second is the possibility that cryptocurrencies would be used to create an unregulated banking system and that companies would borrow money and speculate on cryptocurrencies.

While the debt problem of Evergrande and other real estate companies creates a giant mess, mixing in cryptocurrencies could make an even bigger mess and government policies have been constructed to try to keep the cryptocurrency space isolated from the rest of the Chinese economy.

Why now?

Evergrande has found itself in a difficult situation because the Chinese government issued new rules to restrict loans to real estate companies earlier this year. The Chinese economy has reacted well to COVID, hence the thinking was that now would be an excellent time to deal with overleveraged real estate companies since the general economy could absorb consequences of select defaults.

This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.


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