China confronts its Lehman moment

China’s leaders are often praised for their steady management of the economy. But it is increasingly clear that they are haunted by the specter of a Lehman-style financial collapse.

On Thursday, we learned from a flurry of reports (including in the Wall Street Journal, Financial Times and Bloomberg) that the China Banking Regulatory Commission has ordered the nation’s largest lenders to conduct a sweeping reassessment of their exposure to four high-flying financial conglomerates: Anbang Insurance Group, HNA Group, Fosun International and Dalian Wanda Group.

The focus of the reviews, according to the reports, is to determine whether debts held by the four firms pose a “systemic risk” to China’s financial system. News of the probes sent a chill through markets.

The composition of the CBRC’s corporate “Gang of Four” speaks volumes. The companies are among China’s most flamboyant overseas acquirers. Together they have purchased nearly $57 billion worth of foreign assets over the past five years, more than 15% of total overseas investments by Chinese firms, according to Dealogic.

Anbang (whose chairman mysteriously disappeared this month and is presumed in the custody of Chinese graft inspectors) swallowed the Waldorf Astoria in 2014. HNA has secured a 10% stake in Deutsche Bank and and a 25% stake in the Hilton Hotel Group. Dalian Wanda Group snapped up AMC Entertainment Holdings, the world’s largest cinema operator, then bought Hollywood’s Legendary Entertainment for $2.6 billion. Fosun owns Club Mediterranee and Cirque du Soleil.

The four conglomerates originated in different sectors, but their underlying business model is the same: cultivate powerful allies in the Communist Party; use those relationships to win regulatory and property concessions; gather investment from friends, family and other proxies of party elites into a murky, unregulated private holding company; borrow heavily from state-owed banks and other sources to finance prodigious growth plans; invest as aggressively as possible in stock and property overseas as a hedge against slower growth in China and the risk of a weaker Chinese currency.

The model afforded founders and their privileged backers an efficient way to exploit contradictions in China’s capital control policies. Beijing remains unwilling to let the renminbi trade freely on global currency markets. At the same time, though, party leaders have declared that Chinese companies must “go global” and compete with Western multinationals.

For the past decade, large corporations like Anbang, HNA, Fosun and Wanda were permitted—and even encouraged—to invest billions overseas. As long as they stayed in the good graces of the party elite and could plausibly portray their investments as being in the national interest, regulators mostly turned a blind eye to who owned what, what they were buying and how they were funding their expansion.

No more. As China’s growth show signs of cooling and the Communist Party prepares for its all-important 19th Congress, a cadre of reformers led by CBRC chairman Guo Shuqing is warning that these swashbuckling global buyers aren’t national champions but lightning rods for financial risk.

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In April, Beijing finally moved to clean up the cowboy culture of China’s insurance industry, sacking the nation’s top insurance regulator and restricting the ability of insurers like Anbang and Fosun to finance speculative global acquisitions by selling short-term, high-yield universal life insurance products at home.

But regulators have been slower to deal with soaring corporate debts levels. The Gang of Four is highly leveraged. The fact that their parent companies are unlisted means they have few disclosure requirements. But it also means they face higher borrowing costs. Many have put up their own shares or stock of companies they own as collateral for their loans and are increasingly copying the convoluted fund-raising strategies employed by American hedge funds and private equity firms in financing their global expansion drives. Should the value of those stocks fall, the companies could find themselves obliged to sell off shares to meet margin calls.

Containing the contagion could prove a tricky business. Here’s hoping that in trying to head off China’s Lehman moment, China’s policymakers don’t hasten its arrival.

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