Pacific Money

Misunderstanding China’s Credit Bubble

Rising credit levels are only a symptom. The underlying problem lies elsewhere.

It is not usual for events in a country’s money markets or interbank lending system to garner the attention of the non-financial media. The recent spike in China’s Shibor rates was one of the rare cases when such a story “went mainstream”. Much of the commentary was useful and considered, but there are a few consistent misunderstandings that seem to emerge, especially in online comment sections, whenever someone mentions “China” and “financial crisis” in the same article.

One common argument is that since the much of the debt being built up in China is between various government, and pseudo-government entities (e.g. lending between the state banking system and the state owned enterprises (SOEs)), there will not be a problem. The argument normally centers on the idea that the government can just forgive its own debts to itself, and therefore avoid non-performing loan crises, bank runs and other shocks.  

Obviously it is a bit naïve to assume that China has somehow found a new and foolproof formula for perennially high, problem-free growth. Aside from doubts about whether the premise is correct (not all of China’s runaway debt is clearly government-related), and whether such a “miracle cure” would run smoothly, as well as questions about who is really paying when such things occur, it is important to note that shocking corrective crises may not always be the worst-case scenario. As covered before in Pacific Money and elsewhere, China’s debt buildup is actually a symptom of misallocated investment. Using accounting tricks or other financial magic to hide or “resolve” the former (the debt) allows the latter (the associated wasteful investments) to continue.

Misallocated investment means that the value (wealth) created by a project fails to exceed the value put into it, including all subsidies and externalities – hidden or otherwise. China’s economy contains many forms of these subsidies, but even with them, levels of credit in the economy have been increasing dramatically. These increasing levels of credit are a symptom of the underlying problem, not the problem itself. The blind chasing of headline GDP statistics alone fails to account for whether or not real wealth is being increased or decreased. To simplify, increasing levels of unpaid debt over the long term indicate that investments are not creating the wealth with which to repay them: There is subprime lending going on in China.   

In the United States before its “subprime crisis”, the system misallocating credit was able to continue for much longer than it should have done due to financial innovation (which dispersed the risks but did not resolve them), overly abundant liquidity and a lack of regulatory ability to see and control the problem in time. Financial Innovation of a different nature is proceeding apace in China (the so called “Shadow Banking” system). This is not intrinsically a bad thing, but as in the United States last decade, in this case the innovation is enabling ongoing misallocated lending and investment. Liquidity creation is running wild, with money supply jumping each year since 2008 even as growth slows. Meanwhile, regulators have been struggling to tackle problem areas for years. In other words, China’s system is not efficiently allocating resources.

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Hence, the ability of the Chinese government to “magic away” its debt burden through internal debt forgiveness and accounting or financial trickery is like masking the symptoms of a cancer without treating the underlying condition itself. The Chinese government and financial authorities are well aware of this, even though their predecessors failed to tackle the problem earlier on.  As debts pile up without a proportionate increase in the ability to repay them, eventually there must be a problem.

It is the nature of the problem that seems to cause the most confusion. The problem in China’s context does not have to be massive, shocking, panic-filled crisis. This can possibly be avoided. Certain commentators’ failure to recognize this has caught them out.  However, even if it is avoided, then growth rates will fall as more and more resources are required to forgive, roll-over, subsidize or bail-out the increasing pile of debt.

Alternatively, in the best scenario growth rates will fall as reforms to tackle the underlying issue are brought into effect. In this best-case scenario, eventually real wealth creation will pick up again as the system starts finding and supporting the most value creating projects. There will be winners as well as losers.

Hence, there is thankfully still much impetus for genuine reform, not just quick and easy “miracle cures” which really just delay the inevitable, whilst increasing the overall cost.