China’s debt to GDP ratios are rapidly passing those of more mature western economies with an increasing number of regulators and economists sounding the alarm of a looming crisis. In previous seminars and articles, we have labelled this as the greatest risk for Australian investors. We upgrade the probability of a hard landing
Talk of China’s debt pile has been on our list of top five risks to Australian investors for the past three years. Each year, we’ve upgraded the probability of a hard landing in China creating a financial crisis, or putting such severe constraints on growth that GDP growth slows suddenly.
We have held the view that China is likely to be able to manage a soft landing. In other words, a slow easing of the debt to GDP ratio in a way that eases GDP growth down from 6.5%pa to a more sustainable 3-4%pa. But each year debt ratios have risen further, turning up the dial on the probability of a hard landing, where GDP growth drops suddenly to the 3-4%pa level or even lower, from around a 20% in the first year to a probability to 35-40% last year.
That assessment needs to be adjusted again. Now for the first time, I believe a hard landing scenario is a 50/50 proposition. In this article and next week’s I spell out why.
It’s not the size of the debt that matters, but the rate of growth in debt
There are a lot of theories around about a certain level of debt to GDP ratio being unsustainable or a warning sign of a crisis looming. It isn’t that simple and completely depends upon the individual economy[1].
However, one reliable indicator of excess debt causing a crisis or recession has been the “credit-to-GDP gap”. This measures how much faster debt has been growing compared to GDP. It accumulates year on year showing the total amount by which credit has exceeded GDP over a given timeframe.
The Bank for International Settlements (BIS) considers this to be the single most reliable indicator of a looming financial crisis. BIS found that of its study of 36 countries that had a financial crisis, the majority had a credit-to-GDP gap of more than 10%. Its conclusion was that excessive credit growth is usually followed by a period of well below average credit growth, which is a major drag on economic growth.
Figure 1 below illustrates various economic regions’ experience with credit growth that ran ahead of GDP growth for too long. The first chart shows the world’s largest economies today (excluding EU as the data isn’t available), and includes the property led financial crisis in Japan in the 1980s and the US build up of residential mortgage debt leading up to the GFC. Japan’s build up was much sharper and more extreme, and the payback period famously longer. As shown on that chart, China’s credit-to-GDP gap has grown well past even Japan’s peak.
Europe’s experience includes the 1980s’ Nordic crisis, led by high credit growth, and then the build up of credit in many countries, including Spain and Ireland leading up to the European financial crisis. The higher the gap, the more severe the fall.
The Asian economic crisis of 1998 in which Thailand, South Korea and Indonesia had particularly rapid build up of credit, again resulted in sharper falls the longer the build up: Korea’s gap was not as extreme; while Indonesia and Thailand economy were very severely hit.
In Australia and New Zealand, the pattern is much the same, though Australia’s gap nearly reached 20% in 2008. Fortunately,we avoided a recession thanks to China’s credit fuelled imports covering up the impact of very low credit growth.
Figure 1: Credit-to-GDP Gap is the strongest indicator of a looming financial crisis, typically due to payback period in which credit growth turns sharply negative and drags the economy down
Source: Bank for International Settlements
It’s increasingly becoming a case of “When” not “If”
China’s credit gap will be well past the US and Japans’ peak, suggesting a period of “payback”, and the magnitude of the payback is also rising. The IMF concluded that if credit growth had been kept under the gap threshold of 10%, GDP growth would have been 5.5%pa on average, not the actual 7.25%pa. This gap of 1.75%pa paid back over the next five years would mean growth will fall to 4-5%pa.
Spain, Ireland, Thailand and Japan are good examples of the challenge in trying to pick the timing of a credit fuelled crises. In all cases, the credit-to-GDP gap stayed above 10% for several years. But for these countries, the more the gap grew the more severe or prolonged the payback in terms of lower credit growth. Australia’s 2004-2008 and Norway’s 2006-2012 credit booms were exceptions, where in both cases credit slowed sharply and a crisis was avoided due to growth in demand for exports (coming from China’s own credit growth in both cases).
Macquarie Bank and a growing number of other global banks now call the collapse in China inevitable due to the misalignment of resources and the affected return on equity and debt. Modelling from Deloitte Access Economics suggests that a slowdown in China from 6.5%pa growth to 3%pa would create a recession in Australia, costing 500,000 jobs, a 9% drop in housing prices and a 17% drop in the Australian sharemarket. Construction and mining, not surprisingly, would be hardest hit.
There is no rule that tells us when that will happen, particularly in an economy as unique and tightly controlled as China’s, but the evidence is mounting to suggest the risks for Australian investors are growing each year. Hedging against this risk by selling Australian equities is not likely to be the best option as the timing is so unknown.
Instead investors could look at either reducing higher risk equity positions and holding more of their portfolio in non-AUD positions - so that when China’s downturn comes and the AUD loses value, non-AUD positions will profit.
[1] One thing that can be stated with confidence is that it is the total non banking debt-to-GDP ratio that is including government, corporate and household debt, really matters. Each economy will have its own taxation, political and cultural reasons why debt will accrue in one sector, but ultimately the economy as a whole wears that debt burden one way or another.