5 August 2015

Why the next crisis will start in China


Though the recent slump in the Chinese stock market should be seen within a limited context, there is a strong and growing likelihood of a major financial crash starting in China before, inevitably, spreading globally. The main reason for this is that China has channelled enormous borrowing into the creation of excess capacity, which is analogous to the way in which, before 2008, Western economies used a debt binge to inflate their real estate markets.

Since 2007, China has borrowed $3.90 for each dollar of economic growth, which is exactly what America was doing before the 2008 crash. In fact, spending borrowed money, and treating this as “growth”, was a hallmark of all of the most at-risk economies before the banking crisis. So, too, was the wasteful use of borrowed funds, and the proliferation of “shadow banking”, both of which now characterise China.

That these risks are being widely underrated by global markets is evidence of immense complacency. In the eyes of many, mesmerised by the country’s past successes, China can do no wrong. This complacency is a “China syndrome”, similar to the “Japan syndrome” of the 1980s. How often do we read that China’s economy is “unstoppable”? And how often was that said about Japan in the 1980s?

The Chinese economic transition, from huge exporter to more balanced consumer, is clearly going badly wrong. Debt-addicted China looks increasingly like subprime-shackled America on the brink of the crisis.

The fundamental cause of the 2008 crisis was that, over an extended period, global borrowing far exceeded global growth, in the ratio 3.2:1. Far from learning from the crash, we have actually increased that ratio, adding $3.40 of debt for each $1 increase in global GDP between 2007 and 2014.

If we look more narrowly at “real economy” debt – which excludes the banking sector – the deterioration is even more marked. Between 2000 and 2007, global GDP grew by $17 trillion whilst debt increased by $38 trillion. Since then, nominal growth has again been $17 trillion, but the increase in debt has accelerated, to $49 trillion. This means that each dollar of growth has come at cost of $2.90 in new debt, up from $2.20 between 2000 and 2007.

Pretty obviously, this is indicative of an inability to learn from past mistakes. But the added complication is that the global response to the 2008 crisis hard-wired the next crash into the system.

As well as huge debts that could never be repaid, the authorities became aware in 2008 that simply trying to keep up the payments on this mountain of debt could, of itself, bring down the system. When cutting “policy” interest rates proved to be insufficient, central banks set out to manipulate market interest rates (that is, bond market yields) as well. This was what the creation of money through “quantitative easing” (QE) was really all about.

Though a multiplicity of factors contributed to the 2007-08 banking crash, the fundamental issue was an unsustainably rapid increase in indebtedness in relation to economic output. To be more specific, the problem was an excess of private (rather than state) borrowing. This problem was far worse in some countries (such as America, Britain and, most obviously, Iceland and Ireland), and far more restrained in others. But the overall relationship between debt and growth became inherently unstable in the years before the crash.

Before 2008, seemingly-robust economic growth deluded bankers, policymakers and investors alike into the belief that the growing debt mountain was supportable. What they were missing was that much of the so-called “growth” was really nothing more than the spending of borrowed money. As soon as the capacity to go on borrowing reached some kind of limit, growth would decelerate rapidly. Starting in the summer of 2007, that is exactly what happened.

To assess what is happening now, we need to be a bit more specific about debt, dividing it into three categories. The first of these is financial debt, which is the scale of indebtedness between banks and other financial institutions. This accounted for $17 trillion within the $55 trillion increase in global debt between 2000 and 2007, but has since slackened, contributing $8 trillion to the $57 trillion increase in global debt between 2007 and 2014. We have, to a certain extent, brought banking under tighter control.

If we exclude this banking component, what remains is “real economy” debt. Here, the pace of borrowing has actually accelerated. Real economy debt increased by $38 trillion between 2000 and 2007, but grew by $49 trillion between 2007 and 2014. Therefore, the amount of new debt taken on for each dollar of “growth” has increased, from $2.20 to $2.90.

As 2008 illustrated, a grave imbalance between borrowing and growth makes a crash inevitable. All that then remains is to find a venue, which has to be an economy which is debt-addicted, but which is also big enough to matter. Though many economies (including Iceland, Ireland, Greece and Dubai) borrowed excessively before 2008, none of these was big enough to shake the global system. America, on the other hand, most emphatically was.

Within “real economy” debt, we need, further, to distinguish between state and private borrowing. Globally, both increased between 2000 and 2007 (private debt increasing by $26 trillion and state debt by $12 trillion), but these global aggregates mask some very important geographical distinctions.

In countries like Britain and America, where private debt grew very rapidly, government debt was pretty static. This makes sense, because economies which are booming on the back of escalating private indebtedness enjoy increases in tax revenue, at least until the debt-fuelled boom implodes. British, American and other Western government indebtedness only began to rise after the bubble had burst, when tax revenues slumped, welfare demands increased, and banks had to be bailed out. Government debt ratios, then are a trailing- rather than a leading indicator of debt-fuelled busts.

Fundamentally, private rather than state debt is a leading indicator for crises, because excessive private borrowing can be wasteful. Of course, government borrowing can be wasteful too, but it is unlikely to be exposed as such. If, say, a government was to spend too much on hospitals, or schools, or defence, this might be wasteful, but, being in the non-market sector, it is unlikely to be subjected to financial exposure.

This is where private borrowing is different. As Richard Vague explained in a recent paper, excessive borrowing by the private sector almost certainly means wasteful over-investment. It might amount to pouring too much borrowed money into the housing market, which was what happened in America and Britain. Alternatively, it might take the form of wasteful investment in capacity of one form or another. Either way, it is a hostage to exposure by market forces.

In Britain, the US and elsewhere, wasteful investment in property markets was exposed when servicing the debt became impossible. This had to result in massive bad debts resulting from property market losses, which is exactly what happened until it was stemmed, probably only temporarily, by governments (a) bailing out the banks, and (b) adopting policies of interest rate reduction and the manipulation of market yields. This, of course, and as the Bank for International Settlements noted in a recent report, carries risks of its own.

The other way in which an excess of private borrowing can result in huge losses is where funds are invested in unnecessary capacity. Where this happens, the excess capacity, be it in factories, offices or real estate, will drive returns downwards, making much of the associated debt non-viable.

Looking at what has happened to global indebtedness in recent years, it seems highly probable that the conditions are now in place for a second global financial crash. Since 2007, debt has increased, in relation to economic output, even more rapidly than it did between 2007 and 2014. Meanwhile, the ability of governments to counter a crisis has diminished, for two main reasons. First, governments’ own balance sheets are far more stretched now than they were in 2008, making a banking sector rescue much harder. Second, the policy of manipulating interest rates downwards is hardly an option now, with rates already close to zero.

Given what happened just seven years ago, it may seem strange that the world has again gone down the self-same path of excessive borrowing. There seem to be two main reasons for this apparent irrationality.

First, central bank policy responses to the 2008 crash have made borrowing much cheaper. Globally, the authorities opted for cheap money as the only (or, at least, the most painless and politically acceptable) response to the mountain of debt that had crippled the system. They accomplished this partly by reducing official rates to zero, but mainly by manipulating capital markets using vast sums of money newly created for the purpose. This may have debauched the monetary system as well (indeed, it probably has), but what matters now is that it has resulted in debt growing even more rapidly than in the years before the 2008 crisis.

Second, the world seems incapable of delivering growth by any means other than borrowing. Britain has done better than most at solving this conundrum, reporting growth in real GDP whilst moderating (though not reversing) the accumulation of debt. Even in Britain, however, all is not what it seems. A big chunk of Britain’s growth is attributable to vast sums of compensation paid out by the banks. Even more has been funded by a chronic current account deficit, which last year resulted in the United Kingdom borrowing almost £100bn from foreign lenders, quite aside from being a huge net seller of assets. Borrowing has shifted from the private sector to the British state, and movements within private debt suggest that the emphasis has shifted from investment to consumption, which is precisely the reverse of what the authorities have been trying to accomplish.

If the global picture looks remarkably like it did seven years ago, the geographical distribution has shifted. Just as Western economies have curbed shadow banking and have tried to deleverage, the reverse has been happening in the developing world. Reflecting this, any objective analysis of the situation must identify China as by far the likeliest venue for the next financial crash.

Of the $49 trillion in new real economy debt taken on globally since 2007, $15 trillion, or 31% of it, has been added in China. This amounts to $2.90 of new debt for each $1 increase in nominal GDP over that period.

There are other ways in which China since 2007 has echoed, in an almost uncanny way, what happened in the US and elsewhere in the years preceding the crisis.

For a start, much of the increase in debt has been associated with real estate, which now accounts for almost half of China’s total debt.

Second, the “shadow banking” sector, which was critical in creating huge loss exposure in the US and elsewhere before the crisis, has been growing very rapidly in China, expanding at an annual compound rate of 36% since 2007.

Third, much of the expansion in debt has been in the private (or quasi-private) sector, which, again, is what happened in the West before 2008. Government debt remains pretty low, but the same could be said of America, Britain, Spain and many other economies before the 2008 crisis.

Of course, some optimistic believers in the “China syndrome” of irreversible success argue that China’s low state debt ratio will enable Beijing to engineer a soft landing. It is true, in theory, that increasing the government debt ratio to, say, 80% might not be unreasonable, and would enable China to take on perhaps $3 trillion or more of at-risk debt. The problem with this is the sheer implausibility of China raising new debt of anything like this magnitude. Much the same goes for the notion that China could somehow back-stop private debt losses by liquidating its substantial reserves. These reserves consist largely of un-repayable American IOUs, so any such strategy would simply replace like with like.

Chinese exposure to bad debt risk exposure is hard to quantify, but may well already be in the region $2-3 trillion. This could worsen rapidly were perfectly viable borrowers to be brought down by the failure of those by whom they, in turn, are owed money. The indications are that loss exposure in Chinese property may already far exceed the exposure in US sub-prime that triggered the crash in 2008.

Finally, we need to look at what the sheer quantum of Chinese borrowing tells us about the economy. Chinese GDP continues to grow at impressive rates, but indications are mounting that all is not as it seems. For a start, and like America, Britain and others in the recent past, increments to GDP are far exceeded by additional borrowing. Second, an increasing number of multinational corporates are warning of deteriorating volumes in the Chinese market, whilst factory activity is shrinking.

Most important of all, there is increasing evidence that the excess of private borrowing is being reflected in surplus capacity, which is precisely what one would expect given the link between excessive private borrowing and wasteful investment. As well as inflating its property market, China seems to have built industrial, retail, housing and office capacity far in excess of realistic demand. We should never forget that, whilst GDP includes additions to capacity, the numbers simply record these additions, without warranting their future viability.

In comparison with debt and other fundamentals, gyrations in China’s comparatively small stock markets may not be particularly important, but they are very significant in one way that often fails to attract comment. Essentially, China’s attempt to convert vast swathes of debt into less systemically-risky equity has undoubtedly blown a fuse. This failure may be the shape of things to come.

Tim Morgan was global head of research at Tullett Prebon plc from 2009 to 2013, and is author of Life After Growth (Harriman House, 2013), and numerous influential papers published by the Centre for Policy Studies including A Shower, not a Hurricane: the Modest Nature of the Proposed Cuts (2010), Five Fiscal Fallacies (2011), The Quest for Ideology: how to fill the centre-right ideology gap (2012), Oil, Finance and Pension: why Scots should say No and Countering The “Cost Of Living Crisis” (both 2014).