Why the next crisis will start in China
By Tim Morgan
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.