China and the U.S. China are in the worst position, where 4 units of debt are needed to create 1 until of growth. This suggests a debt “death spiral” ending in a credit crisis, recession, or both.
China is now trapped in a debt death spiral. It cannot afford for growth to slow because that would cause unemployment, bankruptcies, and social unrest. But, it cannot continue growing without massive borrowing and spending programs.
China is Ground Zero for Deflation
This debt problem points to the third element in China’s growth formula, which is deflation. Persistent deflation and disinflation is caused globally by a combination of demographics, debt, deleveraging, and technology.
China is ground zero for global deflation because of its cost structure and its cheap currency that exports deflation to trading partners.
Real growth is calculated as nominal growth minus inflation. A simple example would be an economy with 5% nominal growth and 2% inflation. The real growth would be 3%, (5 – 2 = 3).
Deflation is really “negative inflation.” In converting from nominal to real growth, you are subtracting a negative, which is like adding. For example, an economy with 1% nominal growth and 2% deflation, would have 3% real growth, (1 – (-2) = 3).
This “growth through deflation” dynamic has been playing out in China is recent years. This can produce higher real growth, but it does so with lower nominal growth.
The problem is that debt repayments are nominal. While real growth can be strong in a deflationary period (like in the U.S. in the 1870s), the lack of nominal growth makes it harder to pay off nominal debt. Deflation makes the real value of debt go up, which compounds an already dangerous debt situation.
On the earlier visit to Nanjing, I met with provincial Communist Party officials who took me on a tour of a massive multi-city construction project with office parks, skyscrapers, apartment buildings, hotels, recreational facilities and transportation links for each of the cities. It was all empty.
When we returned for tea in the provincial officials’ offices, I asked how they expected to repay the debt used to fund the construction. The head official answered matter-of-factly, “Oh, we can’t repay it. Beijing will have to bail us out.”
Similarly, a Bloomberg reporter recently interviewed a Chinese bank customer who had just purchased a Wealth Management Products (WMP) from her bank. The reporter asked the customer if she was worried about the credit quality of the loans backing-up her WMP. She replied, “No, not at all. If anything goes wrong, Beijing will bail us out.”
This blind faith in Beijing’s ability to bail out every bad debt in the world’s second largest economy raises the question of Beijing’s willingness and ability to do so.
Higher interest rates will ultimately bankrupt Chinese companies and lead to higher unemployment and slower growth. Look for the Chinese banking system to weaken.
In less than six months, the yuan could finally undergo a maxi-devaluation.
All the best,