China's debt crisis is threatening the world economy

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China's debt crisis is threatening the world economy

The uproar surrounding China's rival Evergrande Group, the world s most indebted property concern, are distracting from China s broader debt problem and slowing economic growth.

China s GDP debt was 270% at the end of 2020, up from 247% one year earlier. The US foreign debt reached $2.4 trillion in 2020. Since 2008, Chinese borrowing, mainly by businesses and households, has risen almost 100% of GDP and accounts for two-thirds of the global debt increase. Evergrande s outstanding debt of more than $300 billion constitutes less than 1% of China s total debt.

China s growth has been driven by government acquired infrastructure and property investment funded by debt, primarily supplied by government-owned banks. Some of the debt is fixed in unproductive or low-returning assets incapable of servicing the borrowings.

In 1993, 1998 and 2004, China successfully negotiated episodes of excessive lending to Provincial governments and State Owned Enterprises SOEs. But this time it is different. The figures involved are larger. Traditionally, China s magic debt shrinking machine involves lenders holding non-performing loans to asset management companies effectively bad banks in exchange for government guaranteed bonds. Then, the time and strong economic growth solves the problem. Rising GDP boosts asset values, which increase in percentage terms the level of debt and non-performing loans to manageable levels.

The unattainable growth rates are now required. At China s current debt levels, which are increasing around 12% - 15% annually, growth of 6% is required to keep debt to GDP stable. The problem is complicated by Chinese government s determination to slow borrowing, which is a driver of growth. China s financial flexibility is overstated. Large foreign exchange reserves ignore accumulated capital liabilities. Based on the IMF standards for China, China needs a massive $300 billion with annual production level of 3 trillion. The amounts needed to reform the economic system and recapitalize the economy would reduce them very much below the minimum IMF level. Given significant illiquid investments, such as Belt and Road Initiative loans and large holdings of U.S. Treasurys, which would be difficult to sell and create undesirable appreciation of the yuan CNYUSD, the realization of reserves may be difficult in any case.

The policy challenge is big. The current crisis was triggered by attempts to restrict lending to developers. Dealing with the legacy of poor quality loans now risks depressing economic activity and setting off a debt crisis. But not addressing the issues will result in a bigger future problem and reckoning.

Fear of social disorder and financial instability mean government intervention is likely. With China's wealth constituting 60% - 75% of the country's household wealth, it will encourage SOEs or others to rescue projects to rescue buyers of unfinished apartments and suppliers. Shareholders and lenders will suffer losses.

Major Chinese lenders will be protected. The country s central bank will help supply liquidity and keep rates low. If a complex wealth management product is offered, domestic savers can lose money. The greater penalty will be from artificially low or negative real rates. The transition from investment to consumption as China s primary economic driver will be delayed.

Foreign investors are vulnerable. The prices of international bonds issued by Chinese property firms have fallen substantially. Ongoing economic disputes with the West, less dependence on overseas capital and increased desire for economic engagement mean default on foreign borrowings is no longer taboo.

Moreover, convoluted lenders may be unable to access prime assets and cash flow due to complex lending structures that result in material losses. After years of berating China for ignoring market disciplines, foreigners could suffer the consequences of their own advice.

If the economy of China is about 30% - 40% of global growth, the slowdown will also affect the Chinese trade partners and consumers.

Investors in emerging market stocks and bonds, either directly or through Chinese ETFs or funds, are at risk. U.S. and Chinese companies income rely on Chinese markets for growth, leaving export-oriented business exposed like automobiles, industrial machinery, aerospace technology and luxury products in the same category.

Commodity and raw materials producers such as Australia, Brazil, and resource businesses, all of which have benefited from the China demand, will see lower incomes. Investors in China-led stocks and bonds, which also benefitted from emerging-market trade and investment, are likely to see knock-on effects.

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Satyajit Das is a former banker. He is the author of A Banquet of Consequences Reloaded: How do we get into this mess we re in and why we need to act now? Also read: The U.S. is playing a game of COVID denial and the financial cost to Americans is dangerously high, even when the national economy is doing it anyway.