‘The sweeter the fruit of habit is, the more bitter its consequences.‘
The habit of debt has been the western world’s sweet fruit for longer than most us can remember.
Mortgages requiring 20% deposits and retailers offering lay-bys are relics of a bygone era of prudent credit management.
Credit cards, lo-doc lending, student loans and margin lending are but a few of the offerings available from the extensive credit menu.
The abundance of sweet credit has created an economy that’s addicted to the sugar fix.
The bitter consequences of the addiction began to be felt in 2008-09 with the GFC.
Policymakers, desperate to avoid the sour aftertaste of the private sector rejecting their decades long sweet habit, have created a world of virtual fruit to maintain the sugar high.
The fruit isn’t real. It has not been created from cultivating the soil. Nor from planting, fertilising and watering the seeds. And certainly not from being patient and waiting for the seeds to bear fruit. There has been no sweat and toil of harvesting.
The ‘we want it now’ world we have become accustomed to has all but abandoned productive behaviour in favour of artificial substitutes.
This mentality means that when it comes to policymakers actually producing ‘fruit’, the programmed response is ‘are you kidding?’ No, our policymakers are too clever for that. They simply hit the button on a 3D printer and hey presto, instant ‘fruit’. As much of it as you like, for as long as you need it.
It certainly looks like fruit, and it appears to have filled the sugar void left by the private sector’s reduced intake of the sweet fruit. But there is something rotten about this manufactured ‘fruit’.
Over the past three decades, the Western world has relinquished its genuine manufacturing role to the Middle Kingdom. China is the maker and we are the taker (using money we do not necessarily have).
Both economic models became dependent upon each other — the more the West consumed, the more China produced. Lower interest rates (making credit cheaper) and the cheap costs of the imports meant the West could indulge this exercise in excessive consumption for a very long time.
Everyone seemed happy. The West was living a life beyond their means. Share and property markets rose significantly. Governments had a greater tax take to fund a growing list of vote-buying welfare promises. And China blossomed into the world’s second largest economy.
But all of this hinged on one critical element — the sweet fruit of debt. Without the massive infusion of debt into the system over the past 30 years, there is no way your shares, property, superannuation, income, welfare payments, or health benefits would be what they are today.
We’ve created a sugar addicted monster that, at the first signs of going ‘warm turkey’, goes into hysteria. The credit retraction, resulting from the GFC, was a mere blimp (a few percentage points) on the debt to GDP ratio chart, and look at the chaos it caused. The global banking system was brought to its knees, and this ushered in the lowest interest rates in history and multiple QEs. Imagine what’s in store if the Great Credit Contraction shrinks the US debt to GDP ratio by 150% or more.
There’s been a lot of focus on how the West (Europe, US and Japan) has been struggling with the post-GFC world of private sector credit contraction. However, the other major beneficiary of the West’s wanton debt funded spending, China, has its own sugar addicted monster to feed.
China has been labelled the miracle economy due to its centrally planned approach to economic management. Consistently delivering impressive quarterly GDP growth figures. Cities, ports and rail networks springing up like mushrooms. Signing multi-billion dollar trade deals. Consuming commodities at a ferocious rate.
It’s been a truly spectacular ascension for what was largely an impoverished country only thirty years ago.
While China is an exporter par excellence, it appears to have fallen victim to the West’s greatest export — a debt addicted economic model.
The following chart from The Financial Times shows the credit expansion experienced in four countries (US, Japan, Korea and UK) prior to the financial crises that eventually befell each of these countries.
Of particular interest to me is Japan. In the 1980s, Japan’s meteoric rise also attracted the label of ‘miracle economy’.
Prior to the bursting of the respective credit bubbles, each of these countries was like the neighbour or work colleague who seemed to have it all. You marveled at their affluence and secretly wondered how they could afford to have a lifestyle so far removed from yours. Then one day the whole charade comes crashing down and the artificiality of their supposed riches is revealed.
Like any household, there’s an ultimate level of debt that can be afforded based on prevailing interest rates and income. The more debt you take on, the closer you are to discovering that tipping point.
The four countries found their tipping point by expanding debt levels (as a percentage of GDP) between 41% and 50% in the years preceding the country’s crisis.
China’s economy, at a debt expansion level of 87%, is in another league, which is precisely why we stare and marvel at the China miracle — it just seems to go on and on. Therefore, we tend to think what has been, will continue to be. In other words, we have developed a level of complacency about China’s capacity to continue to deliver, and the average person rarely questions this premise.
Can China continue going where no other country has been and not reach its tipping point? If you are bullish on equities, you had better hope the answer is yes. If, on the other hand, China does succumb to the debt trap sprung on previous over-leveraged countries, then the fallout will be widespread.
Ratings agency Standard & Poor’s latest research on global corporate debt revealed that China’s listed companies are now the world’s largest corporate borrowers with US$14.2 trillion in debt (compared to the US corporate sector with US$13.1 trillion).
Standard & Poor’s delivered this sobering assessment: ‘The average Chinese company now has worse cash flows and more debt than other similar firms elsewhere in the world.’
The following chart shows that China’s corporate sector has now surpassed Latin America’s to become the world’s highest risk corporate sector. The Standard & Poor’s data suggests red danger signs should be flashing, but complacency about China keeps the signal firmly fixed on green.
click to enlarge
How, in the space of three short years, did China’s corporate sector go from one of the world’s lower risks to its highest risk?
Back in 2009, to counteract the slowing post-GFC Western economy, China’s central planners went about creating their own ‘sweet fruit’. Trillions of dollars were pumped into the system via state-owned banks, to support the real estate market (a huge tax spinner for local governments), steelmaking foundries, the shipbuilding sector and factories for manufacturing exports.
Not all of this readily available state credit was used wisely — hence Standard & Poor’s ‘worse cash flows and more debt’ comment.
The global interconnectivity created by the ‘maker and taker’ economic model of the past 30 years, prompted Standard & Poor’sto sound this warning:‘As the world’s second largest national economy, any significant reverse for China’s corporate sector could quickly spread to other countries.’
You’d think with the knowledge of the fate suffered by other debt laden countries and the Standard & Poor’s warnings, China’s corporate sector would rein in its debt load. Not so.
According to Standard & Poor’s, China’s corporate debt levels are projected to grow by over 60% (to around US$23 Trillion) by 2018. The rate of debt growth clearly outpaces the projected rate of China’s GDP growth (around 7% per annum) over the same period. Perhaps market forces will not give them this luxury.
So who’s going to hit the wall of reality first — Japan, China, the US or one of the Euro basket cases? No one knows. But what we do know is that no country, company or individual in the history of money has ever been able to accumulate debt indefinitely. There has always been and there will always be a day of reckoning. This is the bitter reality that faces us after three sweet decades of debt indulgence.
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