Expected fallout from potential Evergrande collapse

Derek Scissors American Enterprise Institute Senior Fellow joins Yahoo Finance to discuss what's next for the markets as the Evergrande crisis continues to develop.

Video transcript

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- The Dow recording its worst day since mid-July. The S&P and the NASDAQ both recording their worst days since the middle of May. Now, all these as investors are selling on concerns coming out of China and exactly whether or not we could see one of its largest real estate companies, Evergrande, potentially collapse.

We want to talk about this, what this means in terms of the future of China and also what this means for US investors. For that, we want to bring in Derek Scissors. He is AEI Senior Fellow and US China economic and security review commission member. Derek, it's good to see you. I guess, how big of a problem, how major of a problem is this potentially for US investors?

DEREK SCISSORS: I don't think it's much of a problem for US investors. It's certainly a problem for the Chinese property sector. But for it to be a problem for Chinese finance, that doesn't really make any sense. China has a largely non-commercial financial system, where its banks are arms of the government. You cannot get contagion in China the way we get it here. People telling those stories don't understand Chinese finance.

So the way it would affect US investors is if we had a large international investor who was heavily exposed to Evergrande. And that's possible, of course, but we see no admission by anyone. And they've had months, and months, and months to adjust. There are stories about Evergrande's debt problem dating back to spring 2020. So somebody may have made a terrible mistake, but that's what it would take for this to matter a lot to US investors.

- So out of ignorance, I asked the question, where did they get the funding to become so large? Who holds the debt? Who is at risk of losing out, individual Chinese citizens or is it outside investors, who some through different parties might have purchased this?

DEREK SCISSORS: I don't-- I really doubt it's in a large scale. Foreign institutional investors, they tend to be sophisticated. As I said, you've seen this problem coming for a long time. The boom bust cycle in Chinese property is well established. China has excess liquidity. Their money stock is bigger than the US, and Japan, and Britain combined.

So there's a lot of money floating around. Property is a store of value much more in China than it is in most countries because the Chinese stock market is relatively small. And so you just get money naturally diverted to these large developers, because in boom times, you know, prices will soar in Shanghai shore and Beijing-- soar in Beijing. And these companies will do very well. Obviously, no one was ready for the pandemic. And Evergrande was positioned way too aggressively.

So I think what you've got is Chinese investors who are used to property, you know, expansions got caught in this case. But it's very unlikely that experienced institutions will get caught because we've seen this coming from a mile away.

- And Derek, of course, it brings up the question of China's response to it, what that will likely be. How do you see this playing out?

DEREK SCISSORS: Well, there's a moral hazard problem here, obviously, meaning that the Chinese do not want people to think, Oh, if you're really irresponsible like Evergrande, we'll just bail you out. And there'll be no cost and everyone will be fine. Because then, you're going to get another one, and another one, and another one.

So regulators do want there to be a cost. They want Evergrande to suffer. They want some of their investors to suffer. But they'll decide on the basis of what's more to them, who gets bailed out. State banks are not in any danger. Other state financials are not in any danger. You know, there are going to be people probably punished by Chinese regulators that they don't like anyway, maybe some private non-bank financials.

But it'll be a political decision where the Chinese do want some pain, so that people don't do this again. But they won't let Evergrande spread throughout the financial system.

- Do investors here in the United States have a true understanding and an appreciation when they do buy-- they think they're buying stock in a Chinese company when they're actually buying these variable interest entities. They don't actually hold any kind of equity in the company. Do investors here appreciate that and understand the risk they take when they purchase these VIE's?

DEREK SCISSORS: No, not at all. And I would even broaden that that's an absolutely fair point. They are the biggest Chinese companies by market capitalisation. You're not actually buying a stake, where you, you know, an actual piece of that company or buying a piece of a holding company representing it. But I think it's even bigger than that.

A lot of American investors think of China as actually having functioning markets. And in some areas it does. But in finance, it doesn't. As I said, the biggest Chinese banks are all arms of the government. They don't maximize shareholder value, they obey orders. So if you're in the finance sector, you're not getting what you think you're getting. That can be true for a number of other Chinese companies as well.

So between state ownership and the Chinese economy and this VIE structure, a lot of American investors are looking at names and thinking that name is like it has an American equivalent, but it doesn't.

- Derek, how critical of a moment do you see this being just in slowing down the property race that we've seen in China and the aggressiveness that we've seen from that sector? Do you think it's going to significantly change things or are we going to be having a similar conversation in just a couple of years from now?

DEREK SCISSORS: Oh, we'll be having a similar conversation just a couple of years. As I said, property is on a permanent boom bust cycle. That's where most Chinese put their money. Well, savings first, but the return on savings is very low as it is around the world, and then property. We think of the stock market here. First, the bond market, the Chinese think of property. So money goes in and money goes out depending on how people are feeling.

I do think the Chinese government wants property to slow down. I think it's getting what it wants. So I think we're looking at a property downturn. And it's going to be painful for some people. But there'll be an upturn next year and a downturn again two years after that, and so on. So this-- you know, in the short term, this matters to the property sector. It's negative, and property is negative for Chinese growth. But we're going to be back on the upswing sometime in 2022.

- This is a personal question that you don't have to answer, but you are an expert on China. Would you buy an investment tied directly to a Chinese company? Would you personally do that?

DEREK SCISSORS: I would not do that. I have very strong moral objections to the behavior of the current Chinese government. And I find that people who treat China under Xi Jinping to be the same as China under Jiang Zemin, I think that's a sleight of hand. The word China is present, but it's a very different government. So I wouldn't do it for moral reasons.

I also wouldn't do it for practical reasons, because China is clearly engaged in reducing financial transparency. They've told analysts, don't talk too much about the renminbi. Don't blog too much. Don't publish commodities prices as regularly. So instead of a China that's reforming and progressing, you're getting a China that's more opaque. So for either moral or practical reasons, I would not invest in a Chinese entity.