China: It’s Worse Than You Think

Now that China has had its private debt binge, it is entering its bust phase—and the global economy is in for a bumpy ride.

By Richard Vague

Tagged ChinaDebteconomy

China’s stock market tanked badly again last week, and is now down over 40 percent since June 2015. It might be easy to minimize this and conclude that China’s unwary stock market investors have now simply paid for their profligacy. It’s easy to think that China’s economy has just hit a bump in the road and will now endure a further slowing and perhaps a few of years of pain but remain on its path of good growth.

But it’s a lot worse than that as today’s Chinese GDP report suggests. China grew at a rate of 6.9 percent in 2015, its slowest pace in 25 years—only adding to mounting global concerns about China’s economy. My view is that this published rate likely overstates China’s actual current growth rate.

I wrote about China’s impending economic calamity back in 2014 in my book, The Next Economic Disaster, and elaborated on this prediction in an article in Democracy in February 2015. My analysis was centered on private (non-governmental) debt. Economically, what you need to know about private debt is that 1) when a country’s private debt to GDP ratio is low, private debt growth is especially effective in helping to power growth; 2) when that ratio gets higher and private debt grows too rapidly, the result is almost always a severe, calamitous financial crisis; and 3) the residual high private debt levels actually suppress growth since the private sector has to divert income away from investment and spending and toward paying down its private debt.

Runaway private debt growth (defined in larger countries as roughly 20 percent of GDP or more over five straight years) led to essentially all financial crises—including the 2008 crisis in the U.S. and Europe, Japan’s 1991 crisis, the Crash of 1929, and many others. Why? This runaway lending leads to so much overbuilding and overproduction that growth has to be severely curbed in order for demand to catch up, with far too many bad loans made in the process.

The analysis on China is straightforward. The runaway growth in private (non-governmental) debt in China from 2008 to the present dwarfs anything that has ever happened in global economic history. China’s private debt has grown by a massive $16.3 trillion, creating as much as $3 trillion in bad debt in the process. The result is a country littered with ghost cities and piles of commodities including iron and steel. The inevitable bust has begun.

But why will things in China continue to get worse? Because China hasn’t learned anything. China’s private debt growth has reaccelerated to a runaway pace—$805 billion during the last reported quarter alone—and China’s businesses are still overbuilding and overproducing, prodded and aided by China’s government itself. All on top of the years and years worth of overcapacity that already exists.

It’s unprecedented. With almost 50 million empty houses and with big inventories of major commodities, China’s lenders, builders, and manufacturers are still going for more. As one small example, the world, led by China, is still on track to produce as much as 40 percent more iron and steel than it needs this year.

Instead of curbing production and letting real, organic demand catch up with its oversupply—which is the unavoidable requirement to begin rectifying these problems—China is exacerbating this oversupply, ensuring that the eventual reckoning will be all the more difficult. The reason is that its primary concern has long been unemployment, and continuing to produce keeps people employed. Also, continuing to produce allows China to post better GDP growth numbers—they get GDP credit for building a house whether they sell it or not. And perhaps more telling, this is the only strategy China knows—it’s the same one they’ve been using for 30 years.

What will this pain look like? It will be a decade of downward pressure on non-agricultural commodity prices, a deceleration of China’s growth rate to a level near zero, the near-failure of lending institutions (though China has proved a master of propping up insolvent banks), and a potential acceleration of political unrest. If that isn’t enough, all will be accompanied by crisis or near-crisis throughout the Asia-Pacific region, Africa, and South America. In fact, the greater risk may be to all those economies that became dependent on Chinese demand, invariably building their capacity through high growth in private debt.

China is a big part of the oil equation as well, and its decelerating net demand for oil will likely keep prices in the $30 to $40 per barrel range, or lower for some time absent a full-blown war.

Stocks are generally a symptom rather than a cause, and the Shanghai Composite Index, with a price-earnings ratio of 16 (the Dow is currently at 14), has a valuation that is no longer in the stratosphere. However, grave uncertainty about China’s economy and the fragility of China’s corporate earnings, nestled inside the shaky foundation of Chinese accounting standards, could keep China’s stock markets in a troubled mode for some time.

The inevitable slowdown in China is made worse by the fact that there is no other major economy able to pick up the economic growth baton by expanding private debt. Together, the United States, Europe, Japan, and China add up to almost 65 per cent of world GDP. Runaway private debt growth led to Japan’s economic miracle of the 1980s and crash in the 1990s, and it still has residual high private debt levels from this boom that are stultifying its growth rates to near-zero levels 25 years later. Runaway private debt growth led to booms and then busts in the United States and Europe in the 2000s, and the residual high private leverage now impedes their growth.

Now China has had its private debt binge as well and is entering its bust phase. That means that all four of the world’s major drivers of global growth—the United States, Europe, Japan, and China—are now laden with private debt and are facing years of lackluster growth, ensuring long-term downward pressure on commodity prices and interest rates.

The United States will be the least harmed by China of all major countries, but China’s economy, now second largest in the world, is so large that we too will feel at least some of their pain.

The recipe to fix this is obvious. It requires widespread private debt restructuring, recapitalization of lenders, and then time itself to allow for demand to absorb this oversupply. But it goes unheeded—very few agree with or are focused on these things, and instead China is trying the timeworn (and futile) trick of attempting to stimulate continued growth through government intervention.

Fasten your seatbelt.

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Richard Vague is author of The Paradox of DebtThe Case for a Debt JubileeAn Illustrated Business History of the United StatesA Brief History of Doom, andThe Next Economic Disaster. He is a former banking executive and the former Secretary of Banking and Securities for Pennsylvania.

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