In March of this year, an article I wrote titled “The Coming China Crisis” appeared in Democracy. In it, I argued that a rapid rise in private debt was the cause of essentially all major financial crises including our 2008 crisis and Japan’s 1991 crisis, and that the recent dramatic rise in China’s private debt, which has resulted in massive overcapacity in China, would lead to economic pain and a significant deceleration of China’s economic growth.
Since that article appeared, the news in China has been increasingly troubling, highlighted by the stock market collapse in June. While stock market performance is a secondary economic indicator (our own stock market reached an all-time high immediately before our 2008 crisis), I will comment first on that stock market collapse and then on the more central economic indicators in China.
Though the Shanghai Index is down over 25 percent from its June peak, it is still up almost 15 percent this year and over 80 percent from a year ago. Even with this “correction,” however, China’s stocks remain at very high valuations. The average price-earnings ratio on the Shenzhen, a more tech-oriented stock exchange, is still above 50, well above comparable U.S. stocks.
But the precariousness of these valuations becomes more striking when we consider the extraordinary measures the government is taking to boost stock prices. It has demonized short sellers and suspended new IPOs. China’s central bank has injected funds into state-owned entities that lend to brokers to purchase shares. Brokerage firms have pledged to buy 120 billion Yuan worth of securities when the Shanghai Index dips below 4,500. Regulators have relaxed margin requirements, and have gone so far as to allow the use of apartments as collateral. And owners of 5 percent or more of a company are banned from selling any shares for six months.
China’s government will continue to pull new levers to try and prop up its stock markets, but valuation is valuation, and China’s stock markets are valued at levels that are too high. So even if China’s government is able to prop up its stock markets for an extended time, ultimately these valuations are unsustainable and these markets will again move lower.
But a more important factor than the stock market is the continued evidence of massive overcapacity in China’s economy. In large economies (China’s is the second largest in the world), when the private debt-to-GDP ratio increases by 17 percent or more in a five-year period, a financial crisis almost always ensues. That’s because the rapid lending growth signaled by this increase means that far too much of something, such as housing or commercial real estate, has been built—and the result is inevitably both overcapacity and a landslide of bad loans.
Since 2008, China’s private debt has grown by an astonishing 70 percent or $15.5 trillion. This debt financed construction and production far beyond need, as seen in the country’s ghost cities and declining real estate and commodity prices. Prices for building materials like iron, steel, and copper—which were already down significantly—have plummeted another 15 percent, 19 percent, and 9 percent respectively since March. In China and in the world, private debt levels far exceed government debt—and focusing more on private debt levels provides a better insight into the economic status of a country.
Since China’s economy has already produced too much in core areas like real estate, there are precious few high growth opportunities left to power the 7 percent growth that China’s leaders target. Auto sales actually declined 3 percent in June. Producer prices have been falling for three years, evidence of structural overcapacity and softness in the industrial sector. Manufacturing surveys are in contraction territory. Though the official GDP growth rate still exceeds 7 percent, many analysts estimate it is closer to 4 percent, and at least one analyst has estimated that China’s GDP contracted in the first quarter of 2015. Can an economy where auto sales have declined, housing prices are falling, and manufacturing surveys indicate contraction really still be growing at 7 percent? Growth will inevitably slow while demand struggles to catch up with China’s massive oversupply.
When considering all this, some have asked, “What’s so bad about slower growth?” Aside from the fact that it is a far different future than Chinese officials project, my answer is—perhaps nothing. After a high-growth boom in the 1980s very similar to China’s, Japan has had near-zero growth for over 20 years, but has carried on. In 2008, the United States had its greatest crisis since the Great Depression and managed to muddle through. And so will China. But there will be much pain in the process, some of which has already begun—pain for individuals, businesses, and financial institutions within China, and pain for China’s trading partners. The dark cloud, though, is that China has a level of political unrest beyond other major countries that this deceleration may exacerbate. And with China’s deceleration, coupled with lackluster growth in the United States, Europe, and Japan, the world now lacks a high growth engine.
In the past several decades, the world has become more and more highly burdened with private debt, but few have noticed. In 1950, private debt-to-GDP—which begins to noticeably impede growth when it exceeds 100 percent —was 55 percent in the United States. Today it is 146 percent. The four largest Eurozone countries are now collectively over 140 percent (Greece’s private debt ratio grew an eye-popping 66 percent in the five years leading to its crisis). Japan is at 171 percent. China has now joined the high-private-debt club with a whopping 211 percent ratio. Rapid private debt growth brings crisis, and the residual high levels of debt dampen growth. Programs to systemically restructure private debt—such as a regulatory dispensation to restructure underwater mortgages—are the most direct path to restored financial vibrancy. But because these private debt trends have not been widely recognized, and because private debt is largely absent from the world’s leading economic theories, this type of solution is on almost no one’s agenda.