How China’s Mounting Debt Crisis Could Affect the U.S.

China

China’s economy has been growing at a frantic pace for quite a while now. As this growth slows, so does their capacity to pay back debt. Big cracks are now showing.

As much as people complain about regulation, this does serve a valuable function to protect us from ourselves mostly. The implications of inadequate regulation really made the headlines during the credit collapse of 2008, where we got to see what happens if the foxes are allowed to run the henhouses and the hens become thrown under the bus.

When you replace the fat cat bankers who managed to pull one off on their watchdogs with the watchdog itself being the fox, things get even scarier. This is all about transparency or the lack of it, and it was the lack of transparency that did us in with the collapse of mortgage backed securities, where people invested in them and had no idea how dangerous they were, thinking that they were as good as AAA bonds, as good as gold.

It turned out that they were more like spent uranium fuel rods than gold, and as the light became shone on them, we grasped the enormity of this mistake when they exploded and caused a fallout that took a long time and a whole lot of money to fully clean up. We’ve done that now and are hopefully the wiser, but the important thing to realize is that the scale of this massacre was purely caused by not understanding what was really going on and replacing complex realities with nice pictures drawn by young children that you might put on your fridge.

If the risk of these securities were properly represented, we would not have poured trillions into them like we did, and subsequently lost trillions when the lights got turned on. There is nothing wrong with people investing in the most toxic of debt, but we need to understand how risky it is and also seek to be rewarded enough to compensate for us being willing to take it on.

We honestly don’t know how bad things are in China because so much goes on behind the curtain, hidden from view. We might think that this surely can’t go on all that much with modern economies managed by modern governments, but as hip as China’s economy may be compared to where it was during the Mao era, it is still very much an enigma.

Just as big financial institutions would not have wanted to see the great risks that they were taking made too public, China certainly does not want this, and unlike in a democracy, they get to make all the rules, and shape them to whatever best suits them. Looking on this with a dimmer eye is not just a matter of political debate, as financial risk takes no sides and will punish us with the same fury regardless of our political beliefs.

If we had to choose between a country with serious financial threats like China has right now that is ruled authoritative or democratic, we’d pick the authoritative approach every time, and this actually may be China’s saving grace, if there is one. To get things done in a democracy requires at least a semblance of public support, where if you answer to no one other than yourself you are better prepared to do whatever it takes to address these problems.

We still need to keep a close eye on the financial beast that is the Chinese economy, because even though they may be able to put solutions into place that would be well beyond the capacity of a democracy, even the United States, better damage control still leads to more damage, and the scale of this is enormous.

The U.S. surviving the 2008 crisis was far from certain, and things were very much touch and go as the treasury sought to get the political approval it needed to save us. The public had little idea about what went on behind the scenes, as they don’t about China’s inner workings, but the U.S. crisis did have to be worked out politically, and we came very close to a financial collapse greater than the world has ever seen had things not come together as they did.

There is no need for this in China as there is only one party and this is a country where the pen is not only mighty but has absolute power. China also has a lot of capacity to manage things and really only has had to worry about its currency when doing this, at least as far as their chipping away at the part of the iceberg that we can see, which is ominous enough,

What’s below the surface is much larger, and while we’re not even that sure how bad the situation is with China’s debt, the part of the iceberg that we can’t see is estimated at 14 times bigger than the official numbers, which are in themselves scary enough.

When we realize that what brings economies down is exploding defaults, and we remember what happened in 2008, we can at least start to appreciate what sort of risk that we are talking about. Just take 2008 and multiply it by several times.

The Part of the Iceberg in View is Growing at a Disturbing Rate Now

One of the things that we can measure because it all happens above ground is the official default rates. This isn’t just the canary in the coal mine, it’s watching the miners themselves die, and more and more are dying of late.

Loan defaults have been steadily climbing in China over the last 5 years, and this is a trend that is not expected to reverse anytime soon. Improving this isn’t even on the horizon and the reason is that this is due to their looking to run their engines too hot and you can only do this for so long.

What you need to sustain this is growth levels being kept up, and with China’s declining economic numbers, it’s clear that we have reached the apex of red capitalism, and it will just be downhill from here. The real reason for this is that you can only borrow so much before you start getting into trouble, and while governments can just borrow more to get themselves out of trouble, businesses, including banks, cannot, and when we surpass their limitations, they go under.

The biggest threat here isn’t with the rate of increase with the defaults itself, it is with the explosion of debt that is now classified as “doubtful.” China has seen this part of their debt exceed 2008 levels a couple of years back, and this monster continues to grow. As this doubt continues to turn into certainty, credit markets in China are at best in for a very rough ride.

The cornerstone of an economic collapse is bank failure, and this is starting to rear its ugly head in China now. The big banks are fine for now, but a lot of the smaller ones are starting to go under, and this is just going to get worse, not better. This may not even be a manageable situation over the long run, at least if that means managing it without some really bad potential consequences.

People in the U.S. do not care that much about the health of the Chinese economy, which is a lot closer but still pretty distant, but this does matter to the U.S. economy as well because, as they say, things are so connected these days.

We don’t even have to delve into the esoteric world of financial liquidity to appreciate why this should matter. China has done much to fuel the current economic scene, with their still bloated levels of growth. 6% GDP growth is three times higher than we are seeing in the rest of the world, but in China, they have come down to this level. We might think that they can lose another 4% before they even get down to where we are, but their growth raises the level of the ocean so much that this will take us down in tandem.

One of the telltale signs of a shrinking economy is a shrinkage of lending, and this is really happening in China these days. We lend less, we grow less, it’s that simple. We grow less, we have less ability to repay debt, and debt not paid back further depletes the money supply, which further reduces growth. This is a downward spiral that is already well underway, and this aircraft is huge and not one we want to see crash, because the impact it will scatter debris all around the world and could put us in a position ourselves that we cannot manage well.

If not for the power of the Chinese government to manage their economy, it would be headed straight to hell with no chance of recovery when we add up all the numbers. What they can do is do what other governments do, by sweeping dirt under the rug and worry about it in the future, and just keep pushing it ahead as long as you can, and China’s willingness to do this has few limitations.

The Biggest Monsters Can Be Kept Happy if You Feed Them Enough

We do that in the U.S. in a big way, but the difference with China is that they can manage not only state debt but the whole economy this way, and the expectation is that they will continue to intervene on behalf of banks and other companies to keep their placard from getting blown over.

This also does mean that they need to be open to trade at a level never needed before, and the U.S. looking to push them to gain more advantage is very well timed. What would have been met with folded arms not so long ago is now seen as more appealing and even needed.

The Chinese still aspire to being the king of the economic hill and taking the crown away from the U.S., but they need to be careful with pursuing this dream, and keep their empire-building aspirations modest enough. There are some pretty dark clouds on their horizon and they have to focus enough on keeping their house together more before they should be looking too much at buying adjoining properties.

China is also rife with corruption at the corporate level, although we can’t use such a word for the government as there’s no reference point to not needing to answer to anyone. The failure of banks in China these days is blamed both on organic deterioration as well as mismanagement, and the mismanagement part is what set this apart.

China isn’t about to sit back and see bank runs bring down their banks, like we did in the 1930’s, and they did rescue this particular bank and are expected to continue trying to put out these fires as they get out of control. There are a lot of these fires burning right now in the smaller banks in China, who are losing their ability to get enough deposits to run their banks and cannot survive paying rates as high as they are right now.

There are literally thousands of these smaller banks scattered around the country, and some are now worried that the sum of the weight of this risk could lead to a systemic crisis in China. In a free economy, this would look much more like a tsunami heading for our shores, if not for China’s much more effective way of propping these things up than a free economy could ever dream of.

The real saving grace here is that while governments can gobble up a lot of debt, this also causes concerns of currency devaluation, but this is not something that China is so scared of, and in fact would serve to help contain the damage due to its positive effects on their balance of payments. In the trade war, the U.S. wants to keep the value of China’s currency up, not the Chinese, who actually prefer it lower not higher. Spending more therefore helps on three fronts, it’s an economic stimulus, it backstops failures, and it also ends up increasing the value of exports.

Like the U.S., China has a lot of capacity for state debt and they certainly will not be afraid to use it to keep their economy from going too far under. The organic health of China’s banking system may be tenuous, but when you have the party on your side, these dragons will not scare you so much and can also be slayed as long as they don’t grow too large and powerful.

Present-day dragons remain manageable, but we do need to keep a close eye on them, especially with their potential to reduce economic growth worldwide. Our economy is on a nice perch right now but if the tree gets shaken too much, we could be headed to branches lower on it or even the ground if we are not careful, and perhaps even if we are.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.