Concurring with the 10-year anniversary of the fall of Lehman Brothers, Ray Dalio released A Template for Understanding Big Debt Crises, a book that aims to provide a comprehensive approach to debt crises through lessons learned from crises suffered during the 20th century.
Through 471 pages, the author offers a template to understand the Classic Long-Term/Big Debt cycle for two different groups: (1) those with a significant amount of foreign debt and experiencing inflationary depression; and (2) those with debt denominated in local currency and experiencing deflationary depression. Furthermore, the book examines 3 case studies of past financial crises in detail and provides a compendium of 48 debt crises that shocked our world in the past century, providing rough measures for each of the critical phases.
During the last lustrum, a shadow of financial crisis has been flying over China, with a Total Debt of 255.7%, according to the Bank of International Settlements, and the negative from the government to reduce its GDP growth target through monetary tightening initiatives to correct the market. Following Ray Dalio's approach to recognizing debt crises, this article aims to analyze the current situation of China relative to other countries that experienced a similar crisis in the past.
China's recent history
December will mark 40 years since the implementation of economic reforms aiming to transform the country from an isolated land into one of the world's most powerful economies. The openness of the government and the progressive shift from a planned economy to a market economy has brought a remarkable transformation to the agricultural sector first, and to industry and service sectors afterward.
The extraordinary economic performance has been driven by changes in government economic policy, allowing private individuals to own limited liability corporations, unifying the internal market, allowing foreign direct investment in the country, reducing tariffs and abolishing the state export trading monopoly. The creation of the Shanghai Stock Exchange, technological and human capital improvements and the recent inclusions of the yuan in the International Monetary Fund's basket of reserve currencies and Chinese A-shares in the MSCI Index have also had a critical role in attracting foreign capital and making China a global superpower.
Such reforms and the aggressive expansion of its manufacturing capabilities and output allowed China to achieve double-digit GDP growth for three decades, going from $150 billion in 1978 to $12.24 trillion in 2017.
(Source: World Bank)
While labor force was vital during the first part of the 20th century, its contribution to GDP growth has been decreasing since the implementation of the reforms, partly because of an aging population due to the one-child policy. On the contrary, capital accumulation has accounted for a majority of such growth.
(Source: Harvard Business Review)
During the last decade, the government has emphasized transitioning from a manufacturing economy to a services-led one and maintaining a growth rate well above the world average. In 2008, the State Council of the PRC announced a $586 billion stimulus package to minimize the impact of a global financial crisis, and in 2015, President Xi Jinping set a 6.5% growth target in a situation that favored a tighter monetary policy to control the economic market. Failure to meet those targets, combined with further devaluation of the Chinese yuan and further drops in the valuation of the Shanghai Stock Exchange could lead to strains on the liquidity of the financial system and concerns about global deflation.
A Template for Understanding Big Debt Crises - The Bubble
Ray Dalio identifies seven stages of an archetypal long-term debt cycle, by tracking total debt of the economy as a percentage of the total income of the economy (GDP) and the total amount of debt service payments relative to GDP over a period of 12 years.
(Source: Ray Dalio, A Template for Understanding Big Debt Crises. 2018)
Earlier in the cycle, debt growth is being used to finance activities that produce fast income growth. In the first stage of the bubble, debts rise faster than incomes, but central banks progressively decrease interest rates, rising asset prices and people's wealth, and preventing debt service from escalating. At some point, debt service payments become equal or larger than the amount that debtors can borrow.
The bubble starts with a boom of confidence, encouraging new buyers to enter the market not to miss out on the action. As new speculators and unregulated lending institutions (so-called "shadow banks") enter the market, all sorts of entities build up long positions, with debt rising fast and debt service costs rising even faster. As the bubble nears its top, the economy is most vulnerable, with total debt to income levels averaging 300 percent of GDP.
In many cases, monetary policy helps inflate the bubble rather than constrain it, and Central Banks focusing on inflation and growth are often reluctant to tighten money adequately. Only when the market gets fully long, leveraged and overpriced, Central Banks start to tighten, and interest rates rise.
Is China in crisis?
From the following chart we can observe the current levels of debt and debt service for the private non-financial sector:
(Source: Bank of International Settlements)
Due to its high savings and foreign denominated debt of only 7% of GDP, China has been lending money to itself. Debt service above 20% of GDP and the increasing number of corporate-bond defaults ($2.5 billion so far in 2018 vs. $3.13 billion in total 2016) might remind the Chinese government that liquidity injections are not a long-term solution and that a restructuring could be needed in case of further falling profits.
For the first time since May 2017, the yuan has broken the 6.8 barrier to the dollar. Lack of intervention from Chinese authorities suggests that they are, to some extent, allowing the market trade forces to set the currency levels. Sino-US trade tensions, weakening economic data, rising credit events and People's Bank of China (PBOC) easing policy are among the causes behind such devaluation.
However, further economic indicators show the efforts of the Chinese government to reduce risk. The credit to GDP gap indicator, defined as the difference between credit to GDP ratio and its long-term trend, has been narrowing down since the 2015 turmoil. Similarly, short-term rates have increased during the same period, with recent moves responding to the Federal Reserve lift of US benchmark rates.
(Source: Bank of International Settlements)
Shadow banking started to become an issue after 2011 when the liquidity crunch opened new conduits for finance. Today, it has ballooned into an ecosystem driven mostly by traditional commercial banks that have been able to keep shadow-banking assets off their balance sheets to sidestep regulatory constraints on lending.
The Financial Stability Board ranged the relative size of shadow credit in China provided to ultimate borrowers by the end of 2016 between 15% and 70% of GDP, depending on differences in which items are considered as shadow credit and to double-counting. Put into perspective, the size of shadow credit in China is not particularly high compared to those of advanced economies, accounting for 147% of GDP in the UK and 82% in the US.
The case of Japan 1980
The situation in China during the last lustrum has brought to mind the Japanese property bubble burst in 1980 and its implications for the global economy. In 2010, when China's indebtedness reached 200% of GDP, the country's vice-president Xi Jinping asked scholars at the Central Party School to research the subject.
Between 1987 and 1989, Japan experienced a bubble that was driven by a self-reinforcing cycle of rising debt, steady growth and strong asset returns. Debt rose to a pre-crisis peak of 307% of GDP, and equities averaged 28% annualized returns over the bubble period. Policymakers initiated a substantial tightening (with short rates rising around 450 bps) that, taken together with the bubble pressures, created an unsustainable situation. From 1989 to 2013, and ugly deleveraging period occurred, with stock prices and real estate falling by 67% and 43% respectively, increasing unemployment rates and intense pressure for financial institutions.
It is indeed true that some similarities can be drawn between the Japanese crisis and the current state of the Chinese economy:
- The non-financial corporate debt-to-GDP ratios of both China and Japan reached similar levels of about 155%.
- Disturbing demographic trends are another commonality, with a declining working-age population aged 15 to 54.
- Property prices have skyrocketed in Beijing as they did in Tokyo in 1989, with an average of RMB 50,000 per square meter, approximately 50% of the average annual income.
- Both countries have experienced a bullish sentiment after overcoming difficult periods (oil shock in the early 1980s vs. global financial crisis in 2008).
However, there are specific points where the comparisons fail, both in terms of economic fundamentals and macroeconomic policies:
- The tight control that the Chinese government applies over the yuan allows it to shut down speculative behavior, while the Yen strengthened from ¥240 against the dollar to ¥120 in the late 1980s.
- China has managed to move from an export-driven economy to a consumption-driven model, which would give the country more leverage in a potential hit on its Balance of Trade.
- The Bank of Japan maintained an easy policy for a long time after the Plaza Accord in 1985, whereas the PBOC has been much more aware of the financial implications of taking significant risk.
- Two-thirds of the corporate debt in China is owned by State-Owned companies to State-Owed banks, allowing the government to reshuffle debt within the system when needed.
- The Chinese government appears to be adopting three main long-term measures to calm the property bubble and reshape the architecture of China's housing market. Firstly, pushing to develop a market for good-quality rental housing. Secondly, introducing a property tax to keep speculators away. Lastly, striking a better balance between supply and demand by expanding the availability of land where demand for housing is strongest.
A Template for Understanding Big Debt Crises profoundly depicts the singularities of major debt crisis across the 20th and 21st century and helps to draw patterns to predict difficult financial situations that might arise in the future.
While some of those patterns are present in the China of 2018 - rising prices, broad bullish sentiment, tremendous debt-to-GDP, the presence of unregulated lending institutions, stimulative monetary policy focused on growth - a closer inspection brings out the different resources that the government has to avoid the repeatedly announced crisis.
Two of those resources are the recent focus on domestic consumption, making the country less vulnerable to the rising tariffs imposed by the US President, and the full control that the government has over the economy of the country. Furthermore, the Chinese authorities seem to have started to take measures towards risk reduction and controlled yuan depreciation. Yes, a credit bubble bursting would lead to a sharp yuan depreciation and deflationary impact, but the country still has policy tools to avoid such scenario.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.