Is China A Ponzi Scheme?

Chinese economy

Before stepping down as China’s central bank governor, Zhou Xiaochuan made a clear warning to the current political party.

He told them to cut corporate lending, or face their ‘Minsky moment’.

This ‘Minsky moment’ Zhou refers to, comes from the late US economist, Hyman Minsky.

The ‘Minsky Moment’

Minsky argued that long periods of solid growth and rising asset prices, sowed the seeds for future financial panics. Booming times encourage investors to take on more debt. At the same time, 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 that great for lenders either. The losses from multiple borrowers can be enough to drive lenders insolvent.

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 soon found out, borrowing to buy six houses when you can only afford one, eventually leads to disaster.

Victor Shih from the University of California agrees with Zhou. He argues that total credit to China’s non-financial system (including households and local and central governments) stands at around 328% of gross domestic product (GDP), well above the 250% level that is commonly assumed.

China’s Interest Payments Are Rising Fast

In a new paper for the Mercator Institute, Shih believes China’s huge debt burden means China’s interest payments are rising faster than its nominal GDP.

Reported by the Australian Financial Review:

Indeed, in the year ended June 30, total interest payments exceeded the growth in nominal GDP by roughly 8 trillion yuan ($1.6 trillion). “China as a whole is a Ponzi unit”, he concludes.

At present, it appears that this additional interest burden is being capitalised as new loans, which is contributing to the rapid rise in Chinese debt levels. This, says Shih, “is a dynamic which will drive debt growth in China for years to come, or until the debt bubble ends.”

But what will cause the debt bubble to end? Shih argues that, despite China’s massive debt burden, a domestically-triggered crisis is not likely in the next five years. Instead, he says, the trigger is more likely to be some combination of capital flight and the sudden withdrawal of foreign credit.

Shih argues that as debt levels continue to climb, wealthy people tend to start moving money out of the country because of worries about slowing future growth, and the risk that they might be tapped to help bail out the financial system. But as they move money offshore, this depletes foreign exchange reserves, potentially triggering a huge devaluation of the currency, which pushes up inflation and local interest rates, and savages asset prices.

Shih predicts that if China was to default on their debt, it would throw the global financial system into turmoil. I agree with Shih, but of course I don’t see it as a likely scenario.

But that doesn’t mean you shouldn’t prepare for the worst. Click here to find out how to prepare your investments if a recession hits.

Cheers,

Härje Ronngard,

Junior Analyst, Markets & Money

Härje Ronngard

Härje Ronngard

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.  

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