Chapter 6: Debt and Risk

By end of 2018, China's total debt is 258% of GDP, same as America, more than Germany (173%), and much more than some developing countries such as Brazil (158%) and India (123%). And China's debt also grew faster than these countries, 5.5x in 10 years (vs. GDP growth of 2.8x during the same period). Black line China, dash America, dotted Germany, gray line Japan.

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Debt and Economic Recession

In high debt economies, asset prices can plunge when owners cannot meet obligations (eg GFC, numerous crises in China). As asset prices plunge, credit can contract, leading to breaks in the chain of capital.
- For America, whose GDP is 70% consumption, then the housing crisis led to great decline in consumption, pushing the country into recession.

Why is the Debt so High: Lessons from Europe & America

After Bretton Woods was dissolved, currency controls were removed but bank crises appeared. From 1980 to 2010, 153 bank crises (average of 5 a year) took place, vs 2 from 1945 to 1970. What are some lessons?
- By 2008, American banks had leverage of 20x, and total assets exceeded GDP.
- Bank deposits are short term versus the long term nature of loans create risk. While government guarantees alleviate this somewhat, they cannot guarantee everything.
- Most banks like to lend to real estate because of the inherent value of the assets; on average Euro-American banks have about 60% mortgage or real asset loans.
- Finally, financial derivatives are scary. They were about 8% of US GDP right before the GFC.
East Asia "lent" America money because of trade deficits, but Europe & US had a more equal bilateral borrowing situation going on, so the two relationships are fundamentally different. This is why most of the Fed money went to Europe, since the risk was being snowballed from this "you lend to me, I lend to you" scenario.
Another reason for America's debt is due to domestic inequality. Consider a society of 2 people, where the income is $100 and each need $50 to survive. If equally divided, this society has no debt & no savings. But if one person has $100 and the other $0, and one must lend the other $50, then the savings & debt rate both go to 50%.
- In America, most of the debt from the poor is in the form of mortgages, and before the GFC, 70% of American bank loans are to mortgages & real estate related, meaning that most debt weren't towards productive assets, but just the rich lending to the poor.
From 1970s till 2010s, investment by developed countries dropped from 28% to 20%, partly due to the fact that manufacturing moved abroad (such as to China) and also because of the growth of investment into services.
Combine a large supply of capital with enterprises that don't need that much investment, and we have the situation now where developed countries now basically have a long term interest rate of 0. More short-term investments and "financial innovations" are popping up. And there is more wealth inequality as well.
- China recognizes this as a problem, and the PBOC said in 2019 that a loose monetary policy means that those with capital are advantaged, leading to greater wealth disparity and ossifying distortions in economic structure, leading to longer adjustment periods during times of crisis. Which it does not want!

Chinese Debt & Risk

China's rapid debt rise started in 2008.
- Unlike other countries, China doesn't have much foreign debt (just 14% of GDP, international safety standard is 20%), and foreign currency reserves are 2.6x short-term foreign debt (standard is 1x). And even within foreign debt, 35% are denominated in RMB.
2008-10: 4 Trillion Plan (Chapter 3); 2010-11: inflation (pork prices rise), adjustment (more restrictive monetary policy); 2011-15: European debt crisis, more stimulation (lower interest rates, looser lending requirements for local governments), shadow banking; 2015-16: stock market crash, capital flight (RMB devaluation), debt swap for wealth management products explode; 2016-18: "live not speculate" housing policy, decrease capacity, new asset management rules

2018 Total Debt vs. GDP
China has less government debt than developed countries, but more corporate debt (154% in China vs 75% in US and 58% in Germany). This is because equity capital markets are underdeveloped & the percentage of equity vs. debt fundraising is low (total equity markets just ~7Trn RMB).
- Also in corporate debt is a lot of local infrastructure projects by the government investment platforms, which is 40% of GDP (Chapter 3).
There's also the rapid growth of SOEs vs private companies. After 2008, SOEs grew a lot but less efficiently than private companies, so the capital they took up did not translate to corresponding increases in income. From 1998-2007, SOE assets only grew 1.6x, but from 2008-2017, 4.4x (debt increased 4.7x, and grew from 78% to 144% of GDP). Profits as % of GDP decreased from 4.2% to 3.9%, revenues from 72% to 65%.
- Although gap between private cos & SOEs closed after 2012, possibly because those few years were short term gains from investments made by private companies (especially speculating in real estate)
Real Estate industry debt is also a problem, partly because it drives so much of GDP growth (30% in 2013) and accounts for so much of GDP (30 in 2013). In developed countries, developers cannot borrow money to buy land, but in China, they can. By 2018, debt from the real estate industry was 75% of GDP, and lots from shadow banking & other unregulated channels. And pre-sales and personal mortgages account for 50% of cash on hand. But as soon as housing sales decline, this entire capital chain can break down, such as we see with Evergrande. And if real estate companies start having debt crises, it will also hit the financial system and the economy as a whole. Since local governments also rely on selling land for their revenues, this also affects their credit. Thus in August 2020, the central government put out rules on how real estate companies cannot get debt to buy land.
A final point is foreign debt. These real estate companies have no foreign revenue but $174Bn in foreign currency debt. That is also a risk & the NDRC has restricted this since 2019.
Overall, Chinese companies have a heavy debt burden and limited ability to deal with risk. If there is a crisis, then there is risk of default.