Illo: C. J. Burton for Barron’s
China’s Debt Addiction Could Lead to a Financial Crisis
China’s borrowing spree could end badly, with dangerous repercussions for the rest of the world.
By Jonathan R. Laing
The China state-capitalism model was the talk of the annual Davos Economic Conference in 2011. Not only had the Middle Kingdom managed to deftly sidestep the 2008-09 global credit crisis, but its gross domestic product was also growing smartly—up 10.6% in 2010 alone—when much of the emerging and developed world was still wallowing in a slough of economic despond.
These days, however, China has lost much of its economic luster. GDP, or gross domestic product growth has slowed dramatically; the economy expanded by only 6.7% in the first three quarters of this year, according to government reports that most deem wildly inflated. Even so, that’s the slowest growth rate in 25 years. The nation is likewise afflicted with unhealthy asset bubbles that come and go with worrisome rapidity, most recently, last year’s stock market boom and bust.
Spates of asset atrial fibrillation are often precursors of economic trouble, especially in developing economies like China’s. The root problem is that China has relied on mindless monetary stimulus since 2008 to muscle its way to continued output growth. As a consequence, debt levels, mainly corporate borrowings, have surged. According to China finance expert Victor Shih, an associate professor of political economy at the University of California, San Diego, and founder of China Query, the country’s debt load has expanded from 150% of GDP before the onset of the 2008 global credit crisis to about 300%.
That is $30 trillion of debt sitting precariously atop a $10 trillion economy. And, he says, that ratio could rise to more than 330% by next year.
How much of the current $30 trillion in Chinese debt and other impaired financial assets in the financial system is nonproductive, or yielding no net return? For an informed answer, we turned to Charlene Chu in Hong Kong, a widely respected Chinese credit analyst who cut her teeth at Fitch before joining the research shop Autonomous Research Asia. Chu estimates that about 22% of this pile will be nonperforming by year end. And of this troubled paper, totaling $6.6 trillion, actual losses after recoveries are likely to weigh in at more than $4 trillion.
“I don’t know whether China faces a slow burn in economic growth ahead or some kind of financial crisis,” she says. “But you can’t continue on a path of allowing new credit infusions to grow at more than twice the pace of GDP growth.”
THE DEBT TREADMILL China finds itself on these days is best illustrated by looking at its capital-efficiency ratio, or the number of yuan of new credit it takes to produce one yuan of GDP growth. In June, Torsten Slok, chief international economist at Deutsche Bank Securities, published a chart showing that China’s credit bubble exceeded even that of the U.S. in 2007, on the cusp of the subprime mortgage meltdown that set off the global credit crisis.
According to Slok, in 2015 it took more than $450 billion in bank credit to produce one percentage point of GDP growth in China. In the U.S., it took $350 billion to produce one percentage point of GDP growth at peak inefficiency in 2007. As recently as 2008, the amount of credit needed in China was less than half the 2015 number, before China amped up credit growth to levels never scaled by any major economy.
The efficiency ratio has since improved in the U.S., as lenders tightened their credit standards, took huge debt and asset write-downs, and repaired balance sheets with large equity infusions.
China shows no stomach for following a similar path. Deleveraging, or allowing credit growth to go negative, would unleash the baleful forces of widespread business bankruptcies, soaring unemployment, negative economic growth, and, ultimately, massive social unrest.
Among others, hedge fund titan George Soros has predicted a hard landing for the Chinese economy. In a speech delivered last spring in New York at the Asia Society, he asserted that what’s unfolding in China bears an “eerie resemblance” to what happened during the financial crisis in the U.S. in 2007-08, which was “similarly fueled by credit growth.…Most of the money that banks are supplying is needed to keep bad debt and loss-making enterprises alive.”
In a September interview with the BBC, Kenneth Rogoff, a professor of economics at Harvard University, opined that China’s “credit fueled” economy, as the postcrisis “engine of global growth,” is rapidly losing velocity and constitutes a major threat to the world economy. Forget Brexit and other issues. “There is no question. China is the biggest risk,” he said.
Likewise, the Bank for International Settlements issued a review in September showing that China’s banking-system credit had blasted off in the first quarter to a level 30 percentage points above long-run trend levels. The report further warned that even a 10 percentage-point deviation from the trend is “a reliable early-warning indicator of banking crises or severe distress.” Trouble typically arrives “in any of the next three years,” according to the report.
THE CHINESE ECONOMIC apocalypse thesis has been around for several years, pushed by such hedge fund managers as Jim Chanos of Kynikos Associates and Kyle Bass of Hayman Capital Management. While they wait expectantly for Godot, the Chinese economy continues to muddle along, albeit at a slower pace. Beijing has built up plenty of street cred in many international circles after presiding over decades of extraordinary growth.
But that’s not to say there haven’t been some economic tremors in China of late that shook international markets. In the summer of 2015, Chinese stock markets plunged 50% in a matter of months, after government cheerleading and heavy buying on margin drove prices in June of that year to untenable heights.
Then two months later, and again in January 2016, disappointing economic numbers, declines in the value of the yuan, and rampant capital flight from China sent world stock market and commodity prices careening lower.
These China shocks proved temporary, as the authorities resorted to their normal expedient of stepping hard on the monetary accelerator to calm anxieties and revive growth. In this year’s first quarter, Beijing pumped almost one trillion dollars into the economy, a quarterly record for monetary stimulus.
With that, China’s economy appeared to steady, slowing capital flight, and the nation quickly fell off global investors’ list of worries. Complacency vis-à-vis China reigns. Most of its debt is domestically owned and therefore not vulnerable to foreign capital flight. The Chinese are prodigious savers, with a gross savings rate of nearly 50% of GDP, compared with 18% in the U.S., according to the latest World Bank data. Bank deposits tend to be sticky. Like Las Vegas, what happens in China is expected to stay there, or so many global investors apparently believe.
YET RUCHIR SHARMA, chief global strategist at Morgan Stanley Investment Management and author of the recent best seller The Rise and Fall of Nations, is deeply pessimistic about China’s economic prospects.
“It’s scary that China seems to be continuing its debt binge to achieve its unrealistic output growth targets,” he says. “To me, the China economy is like a ping-pong ball falling down a steep staircase, bouncing upward temporarily when credit stimulus is added before continuing its relentless downward path.”
Sharma’s concerns arise from a study, done by his team, of nations that saw their private (corporate and household) debt-to-GDP ratio increase by 40 or more percentage points over a period of five years since 1960. They suffered mightily in the succeeding five years. China’s debt-to-GDP ratio more than doubled that ominous pace between 2009 and 2014.
In all 30 cases studied, output growth slowed by 50% or more over the following half-decade.
Likewise, 18 of the same 30 countries suffered serious financial crises. By Sharma’s reckoning, China is already two years into the throes of a GDP slowdown that figures to get far worse.
DEBT SURGES ARE DESTRUCTIVE for a number of reasons, Sharma says, as their rapid pace leads to sloppy credit practices. Borrowers tend to get increasingly flaky. Asset bubbles develop as easy money triggers unhealthy speculation. Rising collateral values give lenders a false sense of security. All of this also leads to epic misallocations of credit, with money going into increasingly dubious projects and investments. This phenomenon is writ large these days in China.
More than half of the credit that has been extended there since 2008 has gone to nonfinancial state-owned enterprises, or SOEs, even though China’s private sector is far more dynamic and accounts for roughly three-fifths of the Chinese economy. A number of the SOEs are industrial behemoths laid low by declining export growth.
Patrick Chovanec, who taught in the business school at Beijing’s Tsinghua University for five years before moving to New York in 2013 to become chief strategist at Silvercrest Asset Management Group, ticks off a number of examples of gross capital waste during the post-2008 Chinese spending boom.
He points to the mountain ranges of empty apartment buildings that rim Chinese cities large and small, a giant gold-colored statue of Mao, replicas of Beijing Olympic stadiums in third- and fourth-tier cities, bullet trains and toll roads far too expensive for the average citizen to afford, redundant international airports and deepwater ports with little or no business, opulent high-tech centers with no tenants, and exposition centers in improbable locations that sit largely empty throughout the year.
INFRASTRUCTURE INVESTMENT has been a favorite policy lever in China to turbocharge gross domestic product. Even the many white-elephant projects of recent years gave a temporary boost to output during construction, employing hordes of workers and consuming vast amounts of steel, cement, glass, and aluminum. But these projects, showing little or no return on investment over the longer term, became a dead weight on the Chinese economy, requiring ever-growing amounts of new credit to refinance loans and cover debt service.
One can argue that China is structurally susceptible to the kind of debt problems with which it is now struggling. “Capital flows in China these days are largely determined by political connections, state and local government ownership of corporate assets, and the financial interest of the party elite, and not by return on capital and economic viability,” notes Anne Stevenson-Yang, co-founder of China-focused J Capital Research.
In the dog-eat-dog economy, rent-seeking by insiders trumps the public interest. Moral hazard lies at the heart of the system, allowing those with political clout to take risks with the conviction that the state—and ultimately the general public—will always bail them out.
Most of the dodgy paper sits in China’s fast-growing shadow banking system, whose assets now amount to nearly $8 trillion, according to a Moody’s estimate this summer. The shadow institutions—trust companies, brokers, wealth managers, and insurance companies—derive most of their funds from investors looking for higher yields and not directly from bank depositors.
The shadow players, in turn, invest in all manner of assets, from corporate bonds and stocks and loans to local governments for infrastructure projects, to loans to less-creditworthy corporate credits, which are packaged as high-yielding wealth-management products, or WMPs.
Chinese banks also use the shadow market to get nonperforming loans off their balance sheets by injecting the bad loans into WMPs and then buying the WMPs, transmogrifying the bad debt into what they depict as “investment receivables.”
These WMPs are starkly reminiscent of the bad mortgage-backed paper in the U.S. that metastasized in 2008 into a full-blown global credit crisis. The primary problem in the shadow sector, as cited in an International Monetary Fund report this summer, is interconnectedness.
In the mosh pit of China’s current financial system, banks invest in a wide variety of WMPs, and WMPs invest in one another. Layers of liabilities accrete on the very same loans and other damaged paper. Therefore, any debt defaults have the potential to create a full-fledged contagion.
Chu, the credit analyst, estimates that by next year these opaque, off-balance sheet wealth-management products will be double the size of the mortgage-structured investment vehicles and conduits that brought the U.S. banking system to its knees.
THE OVERARCHING QUESTION about China is what catalyst could cause the debt bomb to detonate. One flashpoint could be a collapse in overheated asset markets pumped up by the explosion in monetary growth.
Fortunately for Beijing, the 2015 collapse in the Chinese stock market didn’t hurt that many households. The victims weren’t that numerous—just a bunch of heavily margined punters in cities and the countryside who banked on the misbegotten notion that government stimulus ensured ever-rising stock prices.
Another bubble developed earlier this year in commodity futures markets in iron ore, coking coal, and farm commodities, as prices and trading volume soared, only to subsequently crash. Again, government authorities stepped in to pop the bubble with minimal damage.
But the bubble of all bubbles is unfolding in the housing market, as gobs of new credit are being lavished on developers and home buyers alike.
The market has been on fire, with prices in September soaring year over year by 34.1% in Shenzhen, 32.7% in Shanghai, and 27.8% in Beijing, according to the National Bureau of Statistics of China. Even some secondary cities have seen solid price gains, despite sky-high unsold inventories. Chinese real estate billionaire Wang Jianlin said in a September interview with CNNMoney that the Chinese residential real estate market is now “the biggest bubble in history.”
Indeed, prices have become untethered from local incomes or even any basic need for shelter. Typical investors regard town houses and apartments as pure financial investments and often buy multiple units they don’t bother to live in or even rent out. The latter is deemed to only diminish eventual resale value. The homes are merely stockpiled by investors, whether citizens, SOEs, or banks, in the conviction that growing urbanization will bail them out.
Any major collapse in this most speculative market would have a major impact on the Chinese financial system. Credit directly tied to housing sits at about a third of GDP. Much household wealth would be vaporized. These days, mortgage borrowing accounts for much of the acceleration in household debt levels, which have soared from just over 10% of GDP in 2006 to 40% now.
A substantial dent in household wealth would also play havoc with the nation’s ambition to transform its economy from an industrial export powerhouse to one emphasizing consumption and services.
BY POURING NEW MONEY into its economy, China is also having more difficulty in “managing” the value of its currency, the yuan, which has already declined by 9% versus the dollar in the past 18 months. An oversupply of credit—or, in effect, money—inevitably lowers its value and promotes capital flight from China to more financially hospitable climes.
Despite strong capital controls to inhibit it, there are a number of indications that the capital-flight trend is well entrenched and will only grow in intensity as the yuan continues to weaken.
Chinese buyers are key to real estate bubbles in Sydney, Vancouver, San Francisco, and New York. Last year, for the first time in history, foreign direct investment by Chinese companies exceeded that coming into China. This capital flight springs from many motives, but the overriding consideration is that the economic prospects are better in many climes outside China. And Chinese investors better move quickly before the yuan depreciates more.
So far, the government has been reasonably adept in snuffing out forest fires in various markets, such as the $3 trillion corporate-bond market, heading off defaults by effecting restructurings with still more debt. But what happens if Beijing is overwhelmed by a string of loan defaults or capital leakage outside China?
Then the Chinese debt bomb could well detonate, taking with it broad swaths of the global economy.