#56. Storm Front – part 1

WHY THE NEXT CRISIS WILL START IN CHINA

Though the recent slump in the Chinese equity market should be seen within a limited context, there is a strong and growing likelihood of a major financial crash starting in China before spreading globally.

Since 2007, China has acted like America before the crisis, borrowing $3.90 for each $1 of reported growth. Spending borrowed money, and treating this as “growth”, was a hallmark of the most at-risk economies before the 2008 crash. So, too, were the wasteful use of borrowed funds, and the proliferation of “shadow banking”, both of which now characterise China.

That these risks are being widely underrated by global markets is evidence of immense complacency. In the eyes of many, mesmerised by the country’s past successes, China can do no wrong. This complacency is a “China syndrome”, similar in nature to the “Japan syndrome” of the 1980s. How often do we read that China’s economy is “unstoppable”? How often was that said about Japan in the 1980s?

The Chinese economic transition – from huge exporter to more balanced consumer – is clearly going badly wrong. Debt-addicted China looks increasingly like subprime-hobbled America on the brink of the crisis.

Introduction

Welcome to the first part of “Storm Front”. We’ve covered a lot of ground on this site, but now I want to address a really critical issue – are we heading for a new financial crisis?

I’m convinced that we are. I have never believed that the 2008 banking crash was a complete, “done-and-dusted” event, and nothing that’s happened since has changed this view.

After all, the 2008 crisis happened because we had been borrowing $3.20 for each dollar of growth in the economy. Since then, this has actually worsened, with each dollar of growth now coming at a cost of $3.40 in borrowed money. Globally, debt increased by $55 trillion between 2000 and 2007. Since 2007, debt has grown by a further $57 trillion.

In fact, if we look at what is known as “real economy” debt – which excludes the banking sector – things are much worse now than before the crash. Prior to the 2008 crash, we had taken on new debt of $38 trillion – or $2.20 for each dollar of “growth” – over a seven-year period. Over the subsequent seven years, that number has increased to $49 trillion, or $2.90 for each “growth” dollar.

From this, you might conclude that we seem incapable of learning from our past mistakes. You would be right, but would need to take into account, too, that global responses to the first (2008) crisis hard-wired the next crash into the system.

As well as huge debts that could never be repaid, the authorities became aware in 2008 that simply trying to keep up the payments on this mountain of debt could, of itself, bring down the system. When cutting “policy” interest rates proved to be insufficient, central banks set out to manipulate market interest rates – bond market yields – as well. This was what the creation of money through “quantitative easing” (QE) was really all about.

To understand where things are going, we need to pose three questions:

1. Why does an event like the 2008 crash happen?

2. Are the conditions in place for a re-run of the financial crisis?

3. Where is the next crunch likely to start?

For those who like to cut to the chase, here are some quick answers.

First, a banking crisis occurs when the system has created more debt than it can cope with.

Second, the pre-conditions for a crash are in place now – this need not mean that a crisis is imminent, but it does surely mean that a crash is extremely likely. The relevant questions now are “when?” and “where?”, and perhaps “how?” – but not “if”.

Third, the likeliest start-point for the next crash is China (a view that is not, by the way, particularly influenced by recent turbulence in the Chinese stock market).

1. Why does an event like the 2008 crash happen?

A multiplicity of causes can be cited for the 2007-08 banking crash, and many of them played some part in what happened. What we need, though, is one key lead-indicator, a single metric that can warn that a financial storm front is looming.

That indicator is an unsustainably rapid increase in indebtedness, measured in relation to economic output. More specifically, it is an excess of private borrowing. Why private (rather than state) debt is the problem is explained later.

Of course, the fact that an increase in debt is a pre-condition for a crisis pretty much goes without saying. Between 2000 and 2007, global debt increased by 63%, from $87 trillion to $142 trillion. In the seven years in which this $55 trillion increase in debt was taking place, the nominal value of the world economy increased by just $17 trillion, meaning that each $1 of growth was purchased using $3.20 of new debt.

This ratio was far worse in some countries (such as America, Britain and, most obviously, Iceland and Ireland), and far more restrained in others. But the overall relationship between debt and growth was inherently unstable.

GDP – the general measure of economic output – can be calculated in three main ways. Two of these are income, and gross value added, but the one to focus on here is consumption. Now, if your annual expenditure increased by $17,000, either because you had added $17,000 to value being created in the economy, or because your salary had increased by that amount, that would be one thing. But if your annual expenditure increased by $17,000, but only because you had taken on $55,000 of new debt, that would not amount to an increase in your prosperity. You would simply have mortgaged the future in order to increase your spending today. This would not be a sustainable state of affairs.

In short, expanding GDP simply by spending the proceeds of borrowing is not really “growth” at all. In the pre-2008 years, growth in Britain and America amounted to nothing more than the recycling of borrowed money.

We can be more specific by dividing debt into three categories. The first of these is financial debt, which is the scale of indebtedness between banks and other financial institutions. This accounted for $17 trillion within the $55 trillion increase in global debt between 2000 and 2007.

If we exclude this banking component, what remains is “real economy” or “non-financial” debt. This increased by $38 trillion – from $67 trillion to $105 trillion – in the seven years before the crash. Therefore, each $1 of growth had come at a cost of $2.20 of new “real economy” debt. Again, this number was far higher in countries like Britain and America than in other, more conservative economies. This virtually ensured that a crash, when it came, would occur in one of a limited number of countries.

To qualify as the host venue for a crisis, a country had to meet two criteria.

First, its economy had to be big enough to matter – a crash in a country like Iceland, Ireland, Dubai or Greece would not have been of a magnitude sufficient to undermine the global financial system.

Second, it had to happen in a country where debt had got out of control, and where a boom had taken place on the basis of borrowing.

So the crash virtually had to happen in one of the few countries which were both large enough to matter and reckless enough to hit problems. It could have started in Britain, but it was always likeliest to occur in America, which, of course, was exactly what happened.

“Real economy” debt in turn divides into two categories – state and private. In the 2000-07 period, private and government borrowing contributed $26 trillion and $12 trillion, respectively, to the $38 trillion increase in debt. Geographically, however, there was a starker division, with the private sector accounting for almost all of the debt escalation in countries like Britain and America, where government indebtedness did not increase.

Logically, economies in which private indebtedness is escalating should also be countries where state debt is not under upwards pressure. For a start, an economic boom – even if borrowed, and thus essentially phoney – should, while it lasts, boost tax revenue. Second, the boom should likewise reduce the cost of welfare to government.

The second reason why private rather than state debt flags an impending bust is that excessive private borrowing can be wasteful. Of course, government borrowing can be wasteful too, but it is unlikely to be exposed as such. If, say, the British authorities were to spend too much on hospitals, or schools, or defence, this might be wasteful, but, being in the state sector, it is unlikely to be subjected to financial exposure.

This is where private borrowing is different. Excessive borrowing by the private sector almost certainly means wasteful over-investment. It might amount to pouring too much borrowed money into the housing market, which was what happened in America and Britain.

Alternatively, it might take the form of wasteful investment in capacity of one form or another.

Either way, it is a hostage to exposure.

In Britain, the US and elsewhere, wasteful investment in property markets was exposed when servicing the debt became impossible. This had to result in massive bad debts resulting from property market losses, which is exactly what happened until it was stemmed – probably only temporarily – by governments (a) bailing out the banks, and (b) adopting policies of interest rate reduction and the rigging of market yields. This, of course – and as the Bank for International Settlements noted in a recent report – carries risks of its own.

The other way in which an excess of private borrowing can result in huge losses is where funds are invested in unnecessary capacity. Where this happens, the excess capacity – be it in factories, offices or real estate – will drive returns downwards, making much of the associated debt non-viable.

2. Are the conditions in place for a re-run of the financial crisis?

As we have seen, the financial crash of 2008 resulted from an excess of debt. Looking only at real economy borrowing, global debt increased by $38 trillion during a seven-year period in which nominal GDP increased by just $17 trillion. This meant that each dollar of “growth” had come at a cost of $2.20 in new debt.

In the seven years since the crisis, and far from improving, this ratio has become even worse, with nominal “growth” (again, $17 trillion) happening on the back of $49 trillion of new debt. So the ratio of new debt to each dollar of growth has worsened, to $2.90 from $2.20.

There are several reasons why this has happened. First, central bank policy responses to the 2008 crash have made borrowing much cheaper. Globally, the authorities opted for cheap money as the only – or, at least, the most painless and politically acceptable – response to the mountain of debt that had crippled the system. As we have seen, they accomplished this partly by reducing official rates to zero, but mainly by manipulating capital markets using vast sums of money newly created for the purpose.

This may well have debauched the monetary system as well – indeed, it probably has – but what matters here is that it has resulted in debt growing even more rapidly than in the years before the 2008 crisis.

Second, the world seems to have become incapable of delivering growth by any means other than borrowing. Britain has done better than most at solving this conundrum, reporting growth in real GDP whilst moderating (though not reversing) the accumulation of debt. Even in Britain, however, all is not what it seems. A big chunk of Britain’s growth is attributable to vast sums of compensation paid out by the banks. Even more has been funded by a chronic current account deficit, which last year resulted in the United Kingdom borrowing almost £100bn from foreign lenders, quite aside from being a huge net seller of assets. Borrowing has shifted from the private sector to the British state, and movements within private debt suggest that the emphasis has shifted from investment to consumption, which is precisely the reverse of what the authorities have been trying to accomplish.

3. Where is the next crunch likely to start?

Any objective analysis of the situation must identify China as by far the likeliest venue for the next financial crash. Of the $49 trillion in new real economy debt taken on globally since 2007, $15 trillion – 31% – has been added in China. This amounts to $2.90 of new debt for each $1 increase in nominal GDP over that period. These numbers, by the way, are calculated on a PPP (purchasing power parity) basis, so are not distorted by the official Chinese exchange rate.

There are other ways in which China since 2007 has echoed, in an almost uncanny way, what happened in the US and elsewhere in the years preceding the crisis.

For a start, much of the increase in debt has been associated with real estate, which now accounts for almost half of China’s total debt.

Second, the “shadow banking” sector – critical in creating huge loss exposure in the US and elsewhere before the crisis – has been growing like topsy in China, expanding at an annual compound rate of 36% since 2007.

Third, much of the expansion in debt has been in the private (or quasi-private) sector, which, again, is what happened in the West before 2008. Government debt remains pretty low, but the same could be said of America, Britain, Spain and many other economies before the crisis.

What history teaches us is that state debt ratios tend to expand dramatically after a crisis has taken place, when the government has to assume responsibility for a lot of private, quasi-private or financial sector “toxic assets”.

Of course, some optimistic believers in the ”China syndrome” of irreversible success argue that China’s low state debt ratio will enable Beijing to engineer a soft landing – increasing the state debt ratio to, say, 80% might not be unreasonable, and this would enable China to take on, say, $3 trillion or more of at-risk debt. Those who draw comfort from this observation seem to underestimate the sheer difficulty that China would encounter in trying to raise this kind of money. Likewise, those who believe that China’s huge reserves can be used to fill the gap seem to forget that deploying this would involve selling vast quantities of un-repayable American IOUs to replace equally un-repayable Chinese commercial debt.

One analyst has put Chinese exposure to bad debts in the region $2-3 trillion which, if correct (and it probably is) would inevitably trigger a crisis in which even perfectly viable borrowers could be brought down by the failure of those by whom they, in turn, are owed money.

The indications are that loss exposure in Chinese property already far exceeds the exposure in US sub-prime that triggered the crash in 2008.

Finally, we need to look at what the sheer quantum of Chinese borrowing tells us about the economy. Chinese GDP continues to grow at impressive rates, but indications are mounting that all is not as it seems.

For a start, and like America, Britain and others in the recent past, increments to Chinese GDP are far exceeded by additional borrowing.

Second, an increasing number of multinational corporates are warning of deteriorating volumes in the Chinese market, whilst factory activity is shrinking.

Most important of all, there is increasing evidence that the excess of private borrowing is being reflected in surplus capacity, which is precisely what one would expect given the link between excessive borrowing and wasteful investment. As well as inflating its property market, China seems to have built industrial, retail, housing and office capacity far in excess of realistic demand. We should never forget that GDP includes additions to capacity – but GDP simply records these additions, without warranting their future viability.

As remarked earlier, the gyrations of Chinese stock markets may not be particularly important, but they are very significant in one way that often fails to attract comment – essentially, China’s attempt to convert vast swathes of debt into less systemically-risky equity has undoubtedly blown a fuse.