Economist Warns That China's 'Bear Stearns Moment' May Strike Any Time

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AP Photo/Jin Lee

In the days following China's first-ever default of a corporate bond (Chaori Solar Energy Science and Technology Co's 11 Chaori bond), many tossed around the idea that this was China's 'Bear Stearns moment' or its 'Lehman moment'.

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The fall of investment bank Bear Stearns and the bankruptcy of Lehman Brothers marked key risk events during the great recession.

Chaori's default ended up being neither, writes Lombard Street Research's Diana Choyleva.

"Unlike Bear Stearns, Chaori's default did not change the market's perception of inherent credit risk in the economy, causing a liquidity crunch," writes Choyleva.

This is because it was known for some time that the solar company was in trouble.

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"Nor is it a replay of Lehman's collapse, which triggered a panic partly because it introduced uncertainty about the US government's intentions."

That being said, Choyleva does think that "China's Bear Stearns moment may strike any time."

China's overall debt reached 238% of GDP last year, but even in an extreme case China will find the clean up more manageable. China could "use its ability to absorb loan losses to postpone the debt problem and defer financial market reform," writes Choyleva.

Choyleva argues that with reforms China faces financial distress but that without it the debt will continue to balloon and cause a bigger crisis. "If the leadership opts to mop up the mess while still wasting capital, it could be only 2-3 years before a major financial crisis hits the economy." From Choyleva:

"Debt in China over the past five years has grown much faster than in Japan at the same stage of development. Studies show the rate of increase in debt is as important, if not more important, in precipitating a crisis than the absolute level of debt. On that front, China scores extremely poorly. Japan's debt didn't start to rise at a similar speed until the mid-1980s. China's debt has surged sooner because its economy is much bigger than Japan's was. The world is just not big enough to let China continue to increase its income per capita and waste its savings on a vast scale for years to come. The financial crisis was the beginning of the end of China's export and investment-led growth model."

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Both scenarios could prompt a Bear Stearns moment, but in the reform scenario China will be able to manage the situation.

"If it happens later in a no reform scenario the crisis will be much bigger and China's catch-up growth would be compromised, i.e. China grows at below the rate of global growth for a decade," Choyleva told Business Insider in an email.