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I Told You So: China Debt Reprise

By James H. Nolt

Regular readers of my blog will recall that I warned months ago that China will be the center of the third leg of the world financial crisis since 2007. Now it seems the Bank of International Settlements agrees with me. China’s public and private debt is shooting up like a rocket, far in excess of what is sustainable.

The Bank of International Settlements, or BIS, is one of the more secretive organizations in the secretive world of high finance. It is a central bank for central bankers, headquartered in Switzerland. It was created during first years of the Great Depression of the 1930s to help finance the international payment problems caused by Germany’s World War I reparations. Since then, it has tried to keep on overview of world economic problems and maintain one of the best financial databases, including on otherwise understudied contracts like derivatives.

The BIS is now issuing a warning that China’s debt problems have grown so fast and are so large that they threaten to unhinge the global financial system. Although China’s economy is still second to that of the U.S., its outstanding bank loans are now larger than those of U.S. and Japanese banks combined.

The first table of this article shows that by far the largest component of borrowing in China is by financial institutions. Many China observers do not worry too much about this debt because most banks in China are government owned. Consequently, if faced with crisis, many people assume the Chinese government would bail them out with public funds. Probably Chinese bankers assume this too, allowing them to be more recklessly bullish than typical of private banks.

Financial institutions are often tempted to be bullish because the more loans they make, the more profit they make from the interest payments of their customers. Furthermore, bankers can win more friends and influence by lending generously.

On the other hand, as I have often argued in this blog, excessive credit expansion leads to inflation of whatever prices are stimulated by the lending. For example, if lending is to buy machinery for new factories, machinery prices tend to rise. If most lending is to buy real estate, housing prices rise. If lending expands most to speculators and stock market investors, a stock bubble results. Every major crash in history is preceded by a hot burst of debt-fueled spending that spike asset prices, before the inevitable fall.

Lending is most productive when there is significant excess capacity that can be mobilized by an infusion of new credit. Then firms can borrow in order to expand output, put more people to work, and stimulate real economic growth. However, if excessive credit expansion just raises asset prices higher and higher without raising output proportionately, then a bubble and crash are a likely forecast.

China is a mixed case, so opinions are divided. Some people focus on the significant real growth still occurring, and suggest that its ballooning debt is not a big problem. Future output will be much higher than the debt that can be serviced with more real goods. Others worry that real output is not growing nearly as fast as debt. Thus the only way to service the exploding debt is to squeeze more and more of society’s output from paying wages to paying debts. The creditors who own the debt gain more and more of society’s real product, while those actually producing products get squeezed. This cannot go on for very long, before a peak is reached and everything is thrown into reverse.

One reason for the much-publicized growth of income to the top 1 percent worldwide, is that the debt explosion is global. Creditors tend to be rich. Therefore, when debts expand, so does the income of the richest of the rich. The extreme form of this problem occurs in China today.

Textbook economics does not explain this phenomenon well, because it largely assumes many people are creditors because many people “lend” their money to banks, who then just relend it. But the many who do this earn a pittance in interest on their savings or actually lose money, as is typical in China today, because interest paid to depositor is less than the consumer price inflation rate. Savers are actually suckers slowly losing their wealth to financial corporations that grab most of the profit from lending it.

Economists usually talk only about “the” inflation rate, as if one size fits all. In fact, today in China as in many places, consumer prices are still inflating while wholesale prices are often falling. What this means is that businesses keep raising their final prices to consumers, in part to cover the costs of their own rising debt, even though their own costs (other than debt service) may be falling, which shows up as deflation in the wholesale price index.

The problem is that if you are a producer of raw materials or intermediate goods, such as steel or coal, the prices of what you sell are falling, but your debt service costs are rising. This is a recipe for bankruptcy, or, if your creditors do not force you into bankruptcy, at least non-performing loans. Bankruptcy is still not common in China simply because most government-owned banks are throwing good money after bad and rolling over loans to businesses like these who are caught in a squeeze between falling prices for what they sell and rising loan costs. Bad loans are thus expanding even faster than viable ones. This is unsustainable.

In many business cycles throughout history, at this stage, with the world awash in debt, interest rates would start to rise as creditors become more wary about extending new loans. If interest rates rise, then the most overextended borrowers fail first. Rising interest rates make large debts unbearable. Either these overextended bulls go bankrupt or their debts are covered up for a time and rolled over with new loans in the hope that recovery will allow them to resume payments. Yet if prices stay down and debts continue to pile up, there is no recovery, just a bigger crisis building.

What is odd this time around, is that interest rates have remained at historic low levels despite mountains of debt. It is as if creditors no longer care about ever getting paid back. But that cannot be. Business-minded people do not voluntarily lend money without hope of adequate return. Solving this puzzle is the key to understanding the odd dimensions of the world economic situation today. More on this next week.

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photo Courtesy of moerschy]

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