By John Richardson
HYMAN MINSKY was an American economist who focused his career on studying the causes of financial crises. He developed what he called a ‘financial instability hypothesis” which was based on the notion that long periods of stability sow the seeds of future crises.
His ground breaking work, which is used to explain the roots of the now decade-old Global Financial Crisis (GFC), broke credit cycles into three phases:
- Hedge Financing. Companies and households depend on future cash flows to repay principal and interest on borrowings.
- Speculative Financing. Borrowers rely on cash flows but can only afford to pay back the interest, and not the principal, of debt.
- Ponzi Financing. Cash flows neither cover principal nor interest. Debt can only be serviced by taking out new borrowing.
This article, by US asset management company Crescat Capital, argues that China has now reached Stage 3 – the “Minsky Moment”, where the risk of a financial crisis is very high.
As I have also been warning about since 2008, Crescat points to the extraordinary build-up in lending in China. This was designed to mitigate the impact of the GFC on its economy. In other words, the irony is that the GFC has sown the seeds of what could be the next big global crisis
Debt write-off equivalent to 84% of GDP
The chart at the beginning of this blog post, from Crescat and based on Bank for International Settlements data, places this debt build-up in historical context. As you can see, at more than 200% of GDP, China’s official debt levels are almost as high as those in Japan ahead of its 1990s crisis. Chinese lending is also well in excess of US bank lending ahead of the sub-prime collapse.
This would be OK if most of the lending was productive. But as I have again argued since 2008, the speed with which lending has increased since that year often made good allocation of capital impossible. Chemicals and other plants have often built for the sake of being built – i.e. for the immediate economic multiplier effect of the building activity, with little thought given to long term supply and demand fundamentals.
And Crescat, quoting research carried out by University of Oxford, Saïd Business School, said that over half of China’s infrastructure investments made over the last 30 years had costs larger than the benefits generated. In other words, the projects have destroyed economic value.
So, how do companies that should have gone bankrupt stay above water? And how do banks disguise the true level of their non-performing loans?
In the case of the companies, they have turned to the opaque shadow banking system, from which they are more borrowing money to service existing debts Stage 3 of the Minsky process. This is because their cash flows cannot meet payments of either principal or interest on these debts.
As for the banks, they are beautifying their books by shuffling bad debts off their books and into wealth management products (WMPs) that are being sold to companies and the general public. WMPs are part of the shadow banking system.
The banks hope that China’s booming consumer-driven economy will enable them to at least cover these original bad debts – and perhaps even make money on top of covering these liabilities.
If you add off-balance-sheet shadow lending to the official lending data, China’s total debt position is even more alarming. Crescat quotes research by the UK’s Daily Telegraph newspaper which estimates that when you include shadow lending, China’s debt-to-GDP ratio rises to 650%! This would be by far the highest level in the history of economics.
Crescat provides more details on how this whole process works when it writes:
WMPs are such big business that the Chinese tech juggernauts have gotten in on the game including Alibaba’s subsidiary, Ant Financial, Tencent, Bidu, and JD.com. In our analysis, these companies, wittingly or not, through their “fintech” businesses, have become a central part of China’s grand Ponzi financing scheme.
They have built the platforms for Chinese depositors to easily buy WMPs on their smart phones and indeed Chinese depositors are doing just that. It makes sense that shadow credit is exploding. The problem is that the idea of funding China’s rapidly growing long-term, illiquid, and heavily non-performing assets with rapidly growing short-term, liquid liabilities, all facilitated by the banks and tech companies, and all kept off balance sheet, is a formula for a systemic banking crisis.
Chinese citizens assume that Beijing will always act as back stop on WMPs – i.e. it will either prevent the shadow-banking market from collapsing, or will bail consumers out if these financial products go wrong. The same logic has underpinned the real-estate market. People assume that the government will step into prevent a major collapse in property values.
But Crescat’s view is that at some point either capital outflows and/or bank runs will force the merry go round to stop. The Chinese government will be forced into a quantitative easing programme in order to to recapitalise the banks and support the economy.
This will need to be accompanied by a huge write-off in bad debts. How much? $8.8 trillion of loans which would be equivalent to 84% of China’s GDP, estimates Crescat. That would be more than enough to wipe out all the equity in its Chinese banking system twice over.
This could be a slow motion train crash
Or perhaps China can avoid a train cash altogether. A source of hope is that Xi Jinping and his fellow pro-reform “princelings” have made an important start in the process of weaning China off this kind of excessive and highly speculative lending.
But China faces not only these unprecedented debt problems. It also confronts a drag demand caused by an ageing population. And its export trade also remains vulnerable to a breakdown in global free trade. Who knows what the US might do next?
Fortunately, though, China’s One Belt, One Road (OBOR) initiative offers a solutions to all of the above challenges.
- Industrial and engineering overcapacity is being exported overseas to less-developed OBOR partners where there is latent demand that can absorb this overcapacity.
- Lower-value manufacturing is being outsourced to these partners, with the oil and gas that China needs to boost its energy independence travelling in other direction.
- The OBOR is a hedge against US trade protectionism, as the OBOR region could become the world’s biggest free trade zone.
- The $1 trillion OBOR project could give China the time it needs to escape its middle-income trap, which is the result of an ageing population.
But the OBOR project may not work in time to head off a debt crisis. It may take a generation, or even longer, before the OBOR is really effective. Or the whole project could even fail.
Let’s assume, though, that this is too pessimistic. This still does not mean that the scale of debts in China will not trigger a global economic slowdown, perhaps even a new global crisis. Here is why.
The contagion effect
Let’s assume that at least for the rest of this year and well into 2018, nothing dramatic happens to the Chinese economy. Growth may only moderate a little from a very high H1 2017 base. Capital outflows seem at least temporarily back under control and this may continue. This still doesn’t mean we are out of the woods.
The reason is that the slowdown in lending growth taking place in China today could by itself be enough to trigger major global problems. The problem is expectations. Financial and commodity markets seem to have factored-in no slowdown in China’s economy, and yet slower lending growth will inevitably lead to a deceleration in GDP.
The global economy could thus return to deflation after being reflated by China in 2016 and the first half of this year. This could throw the spotlight on the weak fundamentals of western economies. Western central bank monetary policies have failed to deal with these weak fundamentals.
Consider this: Over the past five years China’s nominal GDP has expanded by $3.7 trillion, an amount that exceeds the GDP of Germany. In contrast, the entire global economy has expanded its nominal GDP by only $2.2 trillion.
Even a moderate slowdown would thus remove a large amount of global growth momentum.
Take another look at the chart at the beginning of this post. Note the credit bubbles in Canada and Australia. These bubbles are very heavily linked to China. Canadian and Australian house prices have soared on the back of Chinese investment. And both countries have benefited from last year’s recovery in commodities prices. This recovery was again down to China.
Also bear in mind that if China muddles through during the rest of 2017 and 2018 without a financial-sector crisis, the sheer scale of its challenges could still negatively affect the global economy.
This negative impact could be compounded by tighter lending conditions in the west as the Fed and the ECB raise interest rates.
When might the tipping point occur? BE careful of this September.