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The heart of the slowdown comes from China, which is already in the midst of its own creeping economic crisis and does not have enough tools to deal with it. For well over a decade, China’s economy has been powered by two main engines: its enormous export-oriented manufacturing sector and its scramble to build cities from scratch, even if no one actually wanted to live in them. In the aftermath of the 2008 crisis, as China’s exports collapsed, the government ordered its state-owned banks to unleash a wave of credit that has been described by economists as the greatest loosening of monetary policy in history. Total debt in the Chinese economy quadrupled from $7 trillion to $28 trillion. At 282% of GDP and climbing, China’s debt load was already bigger last year in relative terms than those of Germany and the U.S. The majority of new credit has gone into property and associated industries such as steel, cement, glass, and factories to produce appliances and products to put in their homes. Much of the debt and construction was taken on by local governments, which were expected to do most of the heavy lifting in boosting GDP and maintaining employment at any cost. The boom continued even as Beijing began to tighten restrictions on lending and housing purchases as it tried to rein in the resulting credit and property bubbles. When investment in real estate finally began to decline this year it prompted the government to reverse its restrictions on credit and property purchases, and significantly loosen monetary policy through interest rate cuts and state-directed bank lending. In recent months, China’s leaders have been in continuous crisis mode, rolling out one stimulus measure after another in their efforts to prop up sagging growth. But attempts to support the real economy have been almost as significant. Income from land sales, which accounted for an average of 40% of local government revenues, has plummeted in the past year. This means local governments are struggling just to service their growing debts and pay for basic public services, and are in no position to contribute to another stimulus program such as the one in 2008. Thanks to the country’s existing debt load, rampant overcapacity and the bursting of property and equity bubbles, China’s available options for stimulating growth are far fewer than they were during past crises. Beijing finally reached for a new tool that it had refrained from deploying for more than two decades – devaluing the currency. This is a risky move because it can trigger currency wars – ultimately leaving the country no better off. It also may have proven to be the ‘canary in the coal mine’ for the current market turbulence, much as the collapse of two Bear Stearns hedge funds in 2007 was the precursor for the mortgage housing crisis that followed in 2008!
Another reason that the U.S. Fed may have refrained from raising interest rates in September was due to cautionary comments from major international bodies such as the IMF and the World Bank, which warned of the risk to global financial markets of such a move. The BIS (Bank of International Settlements) also issued a warning to the U.S. Fed that debt ratios had reached extreme levels across all major regions of the world, leaving the financial system, more vulnerable to monetary tightening (increased interest rates). The Swiss-based BIS said total debt ratios are now significantly higher than they were at the peak of the last credit cycle in 2007, just before the onset of the global financial crisis in 2008. Combined public and private debt has risen to 265% of GDP in the developed economies. Emerging economies have also been drawn into the debt spree, rising to a record 167% of GDP and putting additional upward pressure on their interest rates to attract this capital. China is leading the charge on rising debt, with 235% of debt/GDP, a ratio that is clearly unsustainable for a developing economy and one that has always been associated with a major financial crisis in the past. The Swiss-based BIS says emerging markets have loaded up on debt, lulled by low-interest rates. The ratio of credit to gross domestic product in China, for instance, stands at 25.4 percent – the highest in any major economy – in Turkey it’s as high as 16.6 percent and has swollen to 15.7 percent in Brazil. Early warning indicators of banking stress pointed to risks arising from strong credit growth. Historically, a country with a ratio above a 10-percent threshold has a two-thirds chance of “serious banking strains” occurring within three years, BIS said.
The left panel in the chart below shows how China is reducing its holding of foreign reserves, mostly U.S. Treasury securities, to support the value of its own currency and mitigate the speed at which the Yuan declines. Despite the fact that China had over US$3 trillion in currency reserves, debt in the banking system is ‘multiples’ of that amount and is one of the bigger risks facing that country’s financial system. The right side panel of the chart shows how export growth has gone negative in the past year and is one of the key reasons why we are seeing such a slowdown in China’s economic growth rate. If China does end up devaluing their currency further in order to reverse this export contraction, it will only make things worse in the economies of their emerging market neighbours. Clearly the financial risks are increasing and the Chinese authorities are doing what most investors do in a downturn; sell their most liquid investments or ‘whatever you can!’
