China’s credit boom raises spectre of financial crisis


The world’s leading stock markets delivered exceptional returns over the past 12 months, as the economics of hope – in concert with abundant liquidity – saw investors embrace risk assets enthusiastically.

Global economic activity fell short of consensus estimates throughout 2013, but after three years of decelerating growth most market commentators expect economic momentum to build in 2014 as fiscal headwinds ease in the US and Europe swings from recession to recovery.

Developments in the advanced economies of the West may well point towards stronger global growth – and a diminution of downside tail risks – in 2014, but more attention should be paid to China, the world’s primary growth engine, where attempts to deleverage and rebalance the lopsided economy could weigh more heavily on global economic activity in the months and years ahead than most commentators currently envisage.

The Middle Kingdom’s economy has been moving in a different direction than that of the developed world since the global financial crisis struck more than half a decade ago. While the western world’s private sector has been busy deleveraging balance sheets over the past five years, the Chinese have been engaged
in a credit boom that has seen the outstanding stock of non-financial private and public sector debt jump to dangerous levels relative to GDP.

Growth model exposed
The investment- and export- led growth model that had served China so well over the previous three decades – and particularly so following its accession to the World Trade Organisation in 2001 – was badly exposed by the unprecedented collapse in world trade that accompanied the financial crisis.

Indeed, the near decade- long export surge came to a shuddering end during the winter of 2008, as monthly exports dropped 2 per cent year on year in November and contracted at an annualised rate of more than 25 per cent in early 2009. The adverse impact on the economy called for aggressive stimulus simply to keep the growth engine running. Chinese policymakers responded swiftly to the financial crisis. China’s State Council unveiled a massive stimulus package amounting to four trillion renminbi – 14 per cent of 2008 GDP – in November.

Additionally, the People’s Bank of China adopted an ultra-accommodative monetary policy during the final months of the year. The central bank reduced interest rates five times and lowered required reserve ratios. All told, the fiscal stimulus and monetary expansion combined helped to jump-start economic growth by the second quarter of 2009.

The aggressive crisis response may well have revived economic growth but it also unleashed a lending boom that continues to grow at a faster pace than the economy, despite efforts to slow the rate of credit expansion.

The outstanding stock of non-financial sector debt has more than doubled since 2008, and has increased from less than 150 per cent of GDP five years ago to 220 per cent by the middle of 2013.

China’s outstanding credit relative to GDP is well above its emerging-market peers and roughly 80 percentage points higher than one might expect given the Middle Kingdom’s income per capita.

The absolute size of debt relative to GDP is an important leading indicator of financial crisis and, worryingly, the debt ratio is now at comparable levels to those seen in southeast Asia just before economic turbulence struck in 1997.

Debt ratio surge
Historical data confirms that it is not only the ratio of credit to GDP that conveys important information regarding the potential for financial crisis, but also the speed with which the upward climb in the debt ratio occurs. Indeed, a 45 percentage points jump in Japan’s debt ratio from 1985 to 1990 preceded financial crisis, and so too did the 47 percentage points increase in South Korea’s ratio from 1994 to 1998. Troublingly, the 70 percentage points surge in China’s debt ratio over the past five years is well ahead of either of these historical episodes.

Academic research, most notably a 2012 paper by Mathias Drehmann and Mikael Juselius at the Bank for International Settlements, has demonstrated that the private sector’s debt-service ratio – defined as interest payments and debt repayments divided by income – is a “useful supplementary indicator for the build-up of vulnerabilities in the real economy and financial sector”.

The authors found that a rapid run-up in the private sector debt-service ratio to above 20 to 25 per cent reliably signals the risk of banking crisis and severe economic recession. This was true in Finland in the early 1990s, South Korea in the mid to late 1990s and, more recently, the US and Britain in advance of the most recent global financial crisis.

Once again, the recent Chinese experience is off the charts, with estimates of the private sector debt-service ratio ranging between 30 and 40 per cent. China’s credit boom has seen most reliable leading indicators of financial crisis shift to levels that have preceded economic dislocation in the past. The bulls believe a crisis can be averted, but even a successful deleveraging that reduces debt ratios to more appropriate levels would knock several percentage points off economic growth in the medium term – far more than the consensus currently believes.

The late economist Herbert Stein famously remarked: “If something cannot go on forever it will stop.” Will the Middle Kingdom’s day of reckoning arrive in 2014? Time will tell.

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