China’s economy faces enormous headwinds that will first impede growth, and then likely result in declining growth in the years ahead. Three of these headwinds — real estate, demographics, and geopolitics — will be discussed in this and upcoming editions of The Daily Reckoning Australia. The other critical factors slowing economic growth in China are high debt and low energy reserves.
China is in a debt bubble worse than even Japan or the US. The extent of this debt bubble is obscured by the fact that trillions of dollars of debt are pushed down by the central government in Beijing to the level of provincial governments, state-owned enterprises (SOEs), and major banks. All this debt is de facto guaranteed by the central government; it’s naive or disingenuous to believe otherwise. As a result, this diverse debt must be rolled up to analyse the impact of debt on growth.
Total debt in China (excluding banks) is about US$47 trillion, which is 281% of Chinese GDP. Only about US$5 trillion of this is household debt (see the chart below), leaving US$42 trillion of government and corporate debt. Much of the corporate debt is issued by SOEs, so it is tantamount to government debt. Even on a conservative estimate, government debt in China is at least 250% of GDP. If a bank bailout were required, it would cost about US$1 trillion, or almost 50% of China’s liquid reserves.
The evidence from numerous academic sources is overwhelming: higher debt levels reduce growth. A comfortable debt level is about 30% debt-to-GDP. At levels of 60% or higher, growth slows significantly. Everyday citizens see the debt burden rising and adjust their behaviour, often in the form of higher savings rates in anticipation of higher taxes or inflation that inevitably follow debt debacles.
China is stuck in the debt trap
At 90% debt-to-GDP levels or higher, what physicists call a phase transition occurs. Added output from an additional dollar of debt is less than the dollar borrowed. At lower ratios, a dollar borrowed will produce more than one dollar of growth. But the excess output will shrink as the debt level rises — an example of diminishing marginal returns.
At levels exceeding 90%, returns go negative so that each dollar borrowed produces less than a dollar of growth. Those negative returns increase as the debt level climbs. This is why you can’t borrow your way out of a debt crisis.
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| Source: Refinitiv Datastream/Fathom Consulting |
China is well into this negative marginal return zone. China’s debt situation has gone through the looking glass into a bizarre world from which there is no escape except default, inflation, or confiscatory taxation (or some combination of the three).
The slowdown resulting from excessive debt is beginning to be reflected in Chinese stock markets. Chinese stocks have experienced a substantial drawdown since 1 June 2021. That’s not surprising given the stream of bad news about Evergrande (see below), declining property values, rising coal prices, energy shortages, and increasing geopolitical tensions with the US and its allies.
The overall downtrend has been punctuated by rallies in late July, mid-August, and early October. It’s almost as if markets don’t want to believe just how bad things are in the Chinese economy despite ample evidence that growth is slowing dramatically.
The October bounce back is temporary, with more bad news coming soon. If you’re still clinging to Chinese stocks, this may be your last good exit point for a while. We’re nowhere near the bottom of this.
Freezing in the dark
In addition to a debt trap, China has fallen into an energy trap. Coal prices are rising because of expanding demand, cold weather, and supply chain disruptions. As a result, China imposed price controls on coal by setting a ceiling on price increases.
Of course, price controls never work. They may offer some short-term alleviation, but sooner or later consumers figure out substitutes, structured solutions, or move to an outright black market.
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| Source: The Daily Shot |
China is faced with severe energy shortages now. There’s also good reason to expect a colder-than-average winter. The Chinese will be freezing in the dark in Manchuria and other northern provinces. China is already closing factories on a large scale to conserve energy for residential light and heat. This will get much worse.
The Evergrande effect
Readers have certainly heard of the Evergrande fiasco unfolding in China. Evergrande is the largest property developer and property sales outlet in China. It is highly leveraged and used this leverage to provide mortgages to buyers of its residential units.
Evergrande will not explode in a ‘Lehman moment’. The crisis will emerge gradually, in the form of bad debts written off by banks; corporate failures by those who depended on Evergrande for construction and supply contracts; social unrest from retail investors in wealth management products (WMPs); arrests of executives most involved; depression in the real estate market as investors dump property assets before the coming tsunami of liquidation sales; and write-offs and outright demolition of unfinished projects.
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| Source: The Daily Shot |
The absence of new financing for apartment purchases and Evergrande’s efforts to dump real estate on creditors in lieu of cash have already resulted in declining real estate prices across the board in China.
The Evergrande real estate crisis in China is already starting to have consequences beyond Evergrande itself. Plunging real estate markets triggered by the Evergrande insolvency are affecting other lenders and developers. Home prices in China have begun falling for the first time in six years.
The extent of a financial crisis of this sort is impossible to predict because regulators don’t have enough information about the spiderweb of lending and the extent of counterparty risk to assess how far the damage runs. The process also feeds on itself as each developer failure causes more property to be dumped on the market at fire sale prices, which causes property prices to fall even further — causing more financial distress until the credit wildfire burns itself out.
Regards,
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Jim Rickards,
Strategist, The Daily Reckoning Australia
This content was originally published by Jim Rickards’ Strategic Intelligence Australia, a financial advisory newsletter designed to help you protect your wealth and potentially profit from unseen world events. Learn more here.
