A whiff of 2008 is suddenly turning heads toward China as an AAA-rated state-owned coal mining company defaults.

We’re not necessarily talking about a Lehman Brothers-like disaster that sends ripples of contagion around the globe. And at US$151 million, we’re certainly not talking about a systemically-threatening amount in missed payments.

But the troubles at Yongcheng Coal and Electricity Holding Group are emblematic of where the second-biggest economy finds itself heading into 2021.

It’s a stark reminder that underneath China’s bullish macro narrative lies a shaky microeconomic foundation in need of urgent reinforcement.

Questions abound over how a company in central Henan province that few outside China have ever heard of could have carried the top domestic rating.

At the very least, China’s credit-assessment matrix is having some serious daylight shone its way. Regulators, too, as Beijing works to carve out an international role for Chinese debt, both government and corporate.

The timing is dreadful on another level: Friday’s default capped off 10 days of confusion and intrigue as President Xi Jinping’s team clamped down on China’s tech sector.

The scrapping of Ant Group’s $35-billion mega-listing in Shanghai and Hong Kong was followed up by a series of new rules aimed at curbing monopolistic practices in the internet space.

The moves sent investors reeling. It erased about $290 billion of market value in giants like Alibaba and Tencent over just two days.

These moves being made on various fronts to cap risk among China Inc national champions contrast sharply with festering troubles beyond Xi’s immediate control.

Credit credibility questions

One problem is the lack of transparency regarding where all too many state-owned companies stand.

There’s how troubles in one unit can reverberate across others to affect the parent company, peers across the industry and cast doubt on the health of other state-owned-enterprise bond issuers.

Yongcheng Coal’s stumble has regulators pivoting to investigation mode, probing the interbank bond market.

Where there’s smoke there’s fire, as the old adage goes. For weeks now, credit crunch worries dogged China Evergrande Group. The globe’s most indebted developer owes creditors more than $120 billion. That has foreign investors wondering if what Rosealea Yao of Gavekal Research calls “The Evergrande Effect” is an aberration – or a canary in the China Inc coal mine.

Questions abound over the health of state-run Brilliance Auto. Authorities in Liaoning province, where the local government owns 25% of a venture with BMW, are angling for a court-led debt restructuring. News reports also have authorities looking at the books of chipmaker Tsinghua Unigroup.

What worries Xi’s top finance officials is the unexpected ripple effects that can emerge with each debt event.

In the days since Yongcheng Coal made headlines, local-government debt issues as far away as Yunnan province reacted negatively. The shockwaves have made for volatility reading in the offshore bonds of Yunnan Urban Construction Investment Group.

A number of planned bonds issues among coal-mining operations have been delayed in provinces from Hebei to Shanxi. The fallout is hitting financial stocks more broadly.

On Friday, sell orders targeting mainland banks and insurers pushed the SSE 50 Index of Shanghai’s largest shares down by as much as 2.1%. According to Bloomberg, at least six Chinese banks cut their corporate bond holdings amid default fears.

“Once the credit environment is destroyed, it’s very difficult to rebuild confidence,” says analyst Qu Qing of Jianghai Securities, noting that China needs to head off risks of capital flight just as it’s trying to woo foreign inflows.

Don’t panic! But…

None of this signals an imminent “Lehman moment” for China. It might just be the only top-10 economy to eke out 2% gross domestic product growth in 2020.

Beijing has at least $3.2 trillion of foreign exchange reserves. Nor has the People’s Bank of China gone the quantitative easing route, leaving the central bank considerable latitude to ease. And Xi is surrounded by some very skilled crisis managers.

Recent default troubles, however, highlight the many underlying cracks Xi’s team must shore up in the weeks and months ahead – and credibly so.

Every industrializing nation stumbles at some point amid excess credit and debt. It happened in Japan in 1990, Mexico in 1994, Southeast Asia and South Korea in 1997, Russia in 1998, the US in 2008, Europe in 2010, emerging markets everywhere in 2013. And it could happen in China in 2021.

Emphasis on “could,” of course.

But China has been stuck in this default/market panic loop since 2015, the same year Shanghai’s stock market effectively crashed. In April 2015, Kaisa Group became the first Chinese property developer to default on dollar bonds. It was considered a major point of financial maturity for Xi’s government, one deemed confident enough in market forces to allow a company to renege on debt payments.

By the summer of that year, though, stocks were in freefall. in one three-week period alone in June and July 2015, Shanghai shares fell more than 30%. More than half of listed companies halted trading, while all initial public offerings were delayed.

Slaying 2015’s gremlins

In the years since, China Inc. has worked to raise its financial game.

That meant across-the-board deleveraging efforts: curbing local-government borrowing; limiting risk among financial institutions; reining in the ginormous shadow-banking system; vastly increasing transparency; internationalizing the state sector; and moving upmarket into high-value added sectors.

Xi’s ambitious “Made in China 2025” campaign is all over this last goal.

Over the last month, Xi boldly reaffirmed China’s ambitions to dominate the future of 5G, artificial intelligence, automation, biotechnology, renewable energy, self-driving vehicles, semiconductors, you name it.

He also accelerated plans for a Greater Bay Area experiment in southern China – a “Silicon Valley East” rising at the same time that Covid-19 devastates America’s economic prospects.

When it comes to China’s financial foundations, there’s every reason to think that “in default cases that can lead to systemic risk, the government will step in,” says analyst Ivan Chung of Moody’s Investors Service.

And while that may keep the financial peace over the next three to six months, it’s no replacement for the heavy lifting needed to build a more dynamic financial system that absorbs the odd debt blowup and moves on.

Xi’s ‘to do’ list

Only by increasing transparency, reducing the size of the state sector, and strengthening the corporate ratings system can China break out of a cycle of investors worrying how every small credit stumble puts the entire economic system at risk.

This is a necessary precondition to increasing the yuan’s use in global trade and finance. Since 2016, when China entered the International Monetary Fund’s top-5 currency basket, Beijing has been under pressure to devise a more flexible and resilient financial system.

Turmoil in China’s $45 trillion banking industry would shake global markets. It’s worrying enough that this behemoth is having its worst year profit-wise in a decade amid the Covid-19 fallout.

That had Beijing offering delays on interest and principal payments until March 2021. That could be muddying the extent of trade war-related and coronavirus-related borrowing binges throughout Asia’s biggest economy.

As of September, non-performing loans hit an all-time record at $432 billion, regulators say. Yet rating agencies including S&P Global think the mainland’s ratio of bad loans to assets – which includes potentially shaky debt – may roughly double to 10% from the start of 2020. That could equate to an increase of about $1.2 trillion of non-performing assets.

As we’ve learned from Japan’s 1990s ordeal, bad-debt troubles are best addressed early, often and boldly. Since 2015, Xi’s government displayed bursts of determination to avoid a “Minsky moment,” when a credit-and-debt-fueled boom ends badly.

This doesn’t have to be China’s 2021 – and, odds are, it won’t be.

Yet now is the time for Xi to get under the hood of his economy. The crackdown on the internet sector is intended to curb risks at the very top of China’s corporate ladder. Yet the real threats lurk under the surface. It’s time China brought these threats under control once and for all.