Beware the debt binge: China may just be the next big bubble to pop

Vivek Kaul

In a previous piece I had highlighted the economic dangers that the next government is likely to face. All the factors highlighted in the piece were local in nature. But in the world that we live in today, international factors also play a huge role.
An international factor that needs to be taken into account is China. The Chinese yuan has been depreciating against the dollar since the middle of January 2014. This, after it had been appreciating against the dollar since the middle of 2010.
In the middle of 2010, one dollar was worth around 6.81-6.82 yuan. Since then, the yuan appreciated against the dollar, at a slow and steady pace. And by January 15, 2014, one dollar was around 6.03 yuan. But since January, the yuan has started to depreciate against the dolllar again. As I write this one dollar is worth 6.18 yuan.
So what is happening here? Why has the yuan suddenly changed course? One explanation is that the Chinese economy is slowing down, but that is not visible in the official data that comes out of China. The famed investor Mark Faber
explained this in a recent interview to Bloomberg Television, where he said China is more likely to see 4% economic growth this year than the 7.5% that the Chinese government is targeting.
As Faber said “if you look at the figures of China, exports are still growing. If you look at the trade figures China exports to Taiwan, so China records exports of so and so much. The Taiwan report imports from China at a much lower level. So which figures are more reliable? I think the figures of the trading partners of China are more reliable. And they would suggest that growth has slown down considerably.”
With exports slowing down, it is in the interest of the Chinese central bank to let the yuan to depreciate against the dollar, to ensure that Chinese exporters stay competitive. With the yuan depreciating against the dollar, the Chinese exporters will earn more yuan for every dollar they get paid for their exports. This will ensure that the Chinese exporters stay more competitive in the global market, where several other countries like Japan are rapidly depreciating their currencies against the dollar to get their exports going.
What makes the situation even worse is the fact that China has seen a major credit binge, where Chinese companies have borrowed more and more over the years.
As economist Worth Wray of Mauldin Economics writes in a recent report “China’s total debt-to-GDP (including estimates for shadow banks) grew by roughly 20% per year, from just under 150% in 2008 to nearly than 210% at the end of 2012 … and continued rising in 2013. Even more ominous, corporate debt has soared from 92% in 2008 to 150% today against the expectation that China’s government would always backstop defaults. That makes Chinese corporates the most highly levered in the world and more than twice as levered as US corporates.”
Another interesting data point clearly shows how much debt China has managed to take on in the last few years. “By another measure, China has accounted for more than $15 trillion of the $30 trillion in worldwide credit growth over the last five years, bringing Chinese bank assets to roughly $24 trillion,” writes Wray. So China has accounted to close to 50% of the loans made over the last five years.
What has made the debt particularly addictive is the fact that the new debt is less productive. As Wray puts it “China’s incremental capital/output ratio rose from 2.5x in 2007 to almost 5.5x in 2012. That means it takes more than twice as much debt to generate a given improvement in growth as it did before the debt binge began.”
The Chinese central bank, the People’s Bank of China, did try to rein in this debt binge in 2012, but that immediately led to an economic slowdown. The government stepped in and in July 2013, it ordered the central bank to go easy on things.
As George Soros wrote in a January 2014 column “Aware of the dangers, the People’s Bank of China took steps starting in 2012 to curb the growth of debt; but when the slowdown started to cause real distress in the economy, the Party asserted its supremacy. In July 2013, the leadership ordered the steel industry to restart the furnaces and the PBOC to ease credit. The economy turned around on a dime.”
But that seems to be changing now. One reason is the fact that the government and the central bank are looking to rein in the shadow banking sector, which has been a huge source of loans for the Chinese property companies. China is in the midst of a huge property bubble, which has been on for a while.
As The Economist reports in a recent article “Prices are still rising in 69 of the 70 cities tracked by the official statistics (Wenzhou in Zhejiang province is the exception).”
The Chinese banks have been staying away from lending to the Chinese property sector. But the property companies have managed to continue raising money through the “cash for copper” scheme.
I had explained this in a previous piece, but let me recount it here in brief.
The way this works is as follows. A Chinese speculator manages to raise money in dollars. These dollars he then uses to buy copper. He then sells the copper and gets Chinese yuan in return. He then invests the Chinese yuan in wealth management products, which promise huge returns. The money invested in wealth management products is typically lent to borrowers like property developers to whom the banks are reluctant to lend.
And this has kept the property prices high and property bubble going. The cash for copper scheme works as long as the the Chinese yuan remains stable against the dollar or appreciates. A depreciating yuan makes the cash for copper scheme unviable simply because the speculators need more yuan in order to repay their dollar loan. Also, what has not helped is the fact that the price of copper has been falling.
This is another reason why the Chinese government and the central bank have allowed the yuan to depreciate against the dollar. They want to squeeze out the shadow banking sector. A country like China could easily do with more houses for its huge population. But the trouble, as it is in India, the homes that are being for speculators instead of the masses who need homes to live in. As The Economist writes “One fear is that China’s developers are building houses for the wrong people (speculators) in the wrong places (backwaters). Instead of accommodating China’s overcrowded urban masses, too many houses stand empty, serving as stores of value for people dissatisfied with bank deposits and distrustful of the stockmarket.”
This is something that the Chinese government needs to set right, if they want to continue to stay relevant in the eyes of people. Ultimately, it is worth remembering that China is a capitalistic economy being run by a communist party (which is also the government).
Experts believe that the current government is moving in the direction of popping the domestic debt bubble in China. As Wray writes “China’s ruling elite doesn’t appear to be in denial about its debt problem, as we have come to expect from the United States and the Japan of old. In fact, it seems the new government under President Xi Jinping is intent on popping the domestic debt bubble and allowing widespread defaults rather than continuing to leverage the system into an unmanageable crisis or a Japanese-style stagnation.”
As and when this were to happen (given that predicting when a bubble will pop is next to impossible) it will mean huge problems all over the world, particularly emerging economies. As Faber put it in the Bloomberg TV interview “investors are not sufficiently aware that the Chinese economy is far more important for other emerging economies than the United States because China is a large importer of resources. In other words, iron ore, copper, zinc. And at the same time, they are a huge exporter to commodity producers of their own manufactured goods.”
And this formula won’t work any more. “So if the Chinese economy slows down, commodity prices – industrial commodity prices are likely to remain under pressure. They already come down a lot. They remain under pressure and the resource producers have less money. In other words,…Brazil goes into recession. The Middle East does not grow as much as before. Central Asia, Africa and so forth all contract, and then they buy less from China and you have a vicious cycle on the downside.”
What this also means is that Indian exports will take a huge hit and that in turn will have some impact on economic growth. Also, if China grows at 4%, as predicted by Faber, then what is the Indian economic growth likely to be?

The article originally appeared on on March 25, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)