Why You Should Care About China’s ‘Minsky Moment’

Zhou Xiaochuan is about to step down as governor of China’s central bank, the People’s Bank of China.

Zhou was appointed to the position in 2002. Meaning he saw the collapse of US banks in 2008. He’s seen the huge steps China is making to transform their economy to give more power to consumers.  He’s also witnessed the rapid rise in Chinese corporate debt.

Before his term is up, it’s the latter that Zhou wants to warn everyone about.

China’s Rising Debt Levels

During the 19th National Congress of the Chinese Communist Party, Zhou warned of China’s rising debt levels.

As reported by National Interest, ‘The IMF anticipates that by 2020 China’s domestic credit to GDP ratio will rise to 300 per cent.’ At the moment, China’s corporate-debt-to-GDP sits at around 169%.

If we are too optimistic when things go smoothly, tensions build up, which could lead to a sharp correction, what we call a ‘Minsky moment’. That’s what we should particularly defend against,’ Zhou said. This ‘Minsky moment’ Zhou refers to comes from the late US economist Hyman Minsky.

Minsky argued that long periods of solid growth and rising asset prices sowed the seeds for future financial panics. Boom times encourage investors to take on more debt, while lenders progressively relax their credit standards.

Eventually, investors take on new borrowings, knowing that they won’t be able to repay the principal or even the interest on their loans. Instead, they hope rising asset prices will bail them out.

As you can imagine, borrowers taking on more debt than they can handle is extremely risky. Asset prices can easily fall, leaving them to lose everything. The situation isn’t great for lenders, either. The losses from multiple borrowers can be enough to drive lenders insolvent.

We’ve Seen This Before

If this sounds familiar, it’s because we’ve already seen it all play out in the US. Leading up to 2007, asset prices were soaring, encouraging borrowers to borrow more and lenders to lend more. But as we all found out, borrowing to buy six houses when you can only afford one eventually leads to disaster.

As reported by The Australian Financial Review:

Mr Zhou’s use of the term stunned investors and on Thursday prodded Hong Kong stocks to their worst daily fall of the year. The decline was swiftly reversed on Friday, but it would be unwise to assume that the incident is over. Mr Zhou had issued a clear warning of trouble and unpopular decisions ahead.

‘…We also need to bear in mind the timing of Mr Zhou’s comments, at the congress which gives the regime another five years in power. Now that Mr Xi and colleagues are safely reinstalled, it is the optimum time to take the initially uncomfortable measures that may allow China to avoid a debt unravelling to match the Lehman crisis. Invoking Minsky at the congress itself was the earliest possible point to send the signal, and a sign of urgency.’

So, what does this all mean for Aussie investors? Companies with strong ties to China could suffer the most. If China doesn’t start to rein in corporate borrowing, we could have another 2008 meltdown on our hands.

Härje Ronngard,

Junior Analyst, Markets & Money

PS: If China falls, Australia falls. Prepare yourself for the possible looming recession by clicking here.

Harje Ronngard is a Junior Analyst at Markets and Money. With an academic background in finance and investments, Harje knows how simple, yet difficult investing can be. He has worked with a range of assets classes, from futures to equities. But he’s found his niche in equity valuation. It’s not good enough to be right on average when it comes to investing. The market is volatile and it only takes one bad day to ruin your portfolio. You don’t want to end up like the six foot man that drowned in the river that was five foot deep on average. It’s why Harje is constantly reminding investors of their downside risk here at Markets and Money. He does so by simply asking just two questions.  What is it worth? And how much does it cost? These two questions alone open up a world of investment opportunities which Harje shares with Markets and Money readers. Right now Harje is focused on managing research and investments over at the Legacy Portfolio. An investment publication designed to significantly grow investor’s wealth over time with deeply undervalued businesses. Harje also contributes his insights in Total Income, headed by income specialist Matt Hibbard. Harje loves cash-rich businesses, so he feels right at home amongst Matt’s high yielding income plays.

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