Infographics: China's Debt 'Nuclear' Bomb

The Visual Capitalist has a nifty infographic on China's debt bomb:

NO ONE KNOWS IF ITS A HAND GRENADE OR A NUCLEAR EXPLOSION

The ramp up in Chinese debt accumulation has been a leading concern of investors for years. The average total debt of emerging market economies is 175% of GDP, and skyrocketing corporate non-financial debt has launched China far beyond that number.

The real question is: by how far?

The answer is disconcerting, because nobody really knows.

If the Chinese debt bomb is detonated, the impact on markets is anybody’s guess. Kyle Bass says the losses would be 5x that of the subprime mortgage crisis, while Moody’s says the bomb will be safely disarmed by authorities far before it goes off.

In today’s chart, we look at various estimates to the size of China’s debt bomb, its payload, and what might spark the fuse.

CHINA’S DEBT BOMB: THE PAYLOAD

Mckinsey came out with a widely-publicized estimate of China’s debt at the beginning of 2015. Using figures up to Q2 2014, they estimated that total Chinese debt was 282% of GDP, an increase from 158% in 2007.

Since then, various trusted organizations have come up with follow-up estimates.

On the low end, Goldman Sachs came out with an estimate in January 2016 of 216% total debt-to-GDP for 2015. (A few months later, they put out a separate report saying that total debt-to-GDP was estimated to be closer to 270% for 2016.)

On the high end, Macquarie analyst Viktor Shvets said that China’s debt was $35 trillion, or “nearly 350%” of GDP.

The truth is that it’s anybody’s guess. China’s official estimates are fairly useless, and the country has a massive and quickly evolving shadow banking sector that complicates these projections significantly.

EXPLOSIVE MATERIALS

Total debt is made up of various components, including government, corporate, banking, and household debts.

In the case of China, it is corporate debt that is particularly explosive. According to Mckinsey, the country’s corporate sector already has a higher debt-to-GDP than the United States, Canada, South Korea, or Germany, even while still being considered an “emerging market”.

S&P Global Ratings now figures that Chinese corporate debt is in the 160% range, up from 98% in 2008. The current number in the United States is a less ominous 70%.

China’s central bank is just as concerned as anyone else. Here’s what the Governor of the People’s Bank of China, Zhou Xiaochuan, had to say about a month ago:

Lending as a share of GDP, especially corporate lending as a share of GDP, is too high.

Xiaochuan also noted that a high leverage ratio is more prone to macroeconomic risk.

DEFUSING THE BOMB

If there’s something that can ignite the fuse of China’s debt bomb, it’s non-performing loans (NPLs).

An NPL is a sum of money borrowed upon which the debtor has not made scheduled payments. They are essentially loans that are either close to defaulting, or already in default territory.

China has an official estimate for this number, and it is a benign 1.7% of debt. Unfortunately, independent researchers peg it much higher.

Bullish analysts have the number pegged in the high single-digits, while bearish analysts put the range anywhere between 15% and 21%. Even the IMF says that loans “potentially at risk” would be equal to 15.5% of total commercial lending.

If there’s a place to start defusing the bomb, this is it.

My comment: 

Debt represents a symptom of an underlying disease. The question is what is the disease, or what has debt been used for? In China’s case, debt had been used to finance gigantic non productive, speculative investments in various sectors as industrial, infrastructure and property. This means that China’s debt explosion funded rampant excess capacity. And excess capacity represents another secondary symptom. Hence, China’s debt financed overcapacity can be construed as a massive misallocation of resources or malinvestments.

And much of the malinvestments emerged out of the Chinese government’s attempt to shield her economy from the Great Recession, mostly through financial repression via inflationism and government directed investments, the $586 stimulus, mostly channeled through the local government. And local governments circumvented rules on direct investments to use the private sector to deliver the political economic goodies which had been financed by the debt. Thus the corporate debt explosion.

While it has been speculated that debt may be controlled or “disarmed” by the government, debt is not just a number. As noted above, debt has been entwined to China’s severely maladjusted economy. This means that when the pool of real savings in the economy has been severely undermined or has been depleted from malinvestments, then the Chinese economy is headed for an economic slump. 

The Chinese government can act to delay the bust, as they have been doing today, but this comes at the cost of a deeper, and most likely violent market clearing process, which should lead to a coming depression.

In short, the obverse side of an inflationism fueled artificial boom is an inevitable crash.

As the great Austrian economist Ludwig von Mises once warned:

Credit expansion cannot increase the supply of real goods. It merely brings about a rearrangement. It diverts capital investment away from the course prescribed by the state of economic wealth and market conditions. It causes production to pursue paths which it would not follow unless the economy were to acquire an increase in material goods. As a result, the upswing lacks a solid base. It is not real prosperity. It is illusory prosperity. It did not develop from an increase in economic wealth. Rather, it arose because the credit expansion created the illusion of such an increase. Sooner or later it must become apparent that this economic situation is built on sand.

Sooner or later, credit expansion, through the creation of additional fiduciary media, must come to a standstill. Even if the banks wanted to, they could not carry on this policy indefinitely, not even if they were being forced to do so by the strongest pressure from outside. The continuing increase in the quantity of fiduciary media leads to continual price increases. Inflation can continue only so long as the opinion persists that it will stop in the foreseeable future. However, once the conviction gains a foothold that the inflation will not come to a halt, then a panic breaks out. In evaluating money and commodities, the public takes anticipated price increases into account in advance. As a consequence, prices race erratically upward out of all bounds. People turn away from using money which is compromised by the increase in fiduciary media. They "flee" to foreign money, metal bars, "real values," barter. In short, the currency breaks down.

Courtesy of: Visual Capitalist