When pondering the problems plaguing the Chinese economy, Chinese stocks and global equity markets intimately linked to the Red Dragon’s fortunes, the first thing that usually comes to mind is the marked slowdown in gross domestic product growth.
Yet the bigger problem in China is not so much its growth rate, but its massive and ever-increasing total debt.
China’s external debt had swollen to $1.68 trillion at the end of the second quarter, up from $1.03 trillion in the first quarter, according to the official data from the State Administration of Foreign Exchange. The breakdown of that debt was $1.17 trillion in short-term debt, with the rest in medium- and long-term debt.
Perhaps even more troubling for the Chinese economy and stocks and China’s debt is the country’s record debt-to-GDP ratio.
According to data compiled by Bloomberg, at the end of June, outstanding loans for companies and households had reached a record 207% of gross domestic product. That’s a marked increase of nearly 66% from the 125% debt-to-GDP ratio China had in 2008.
Bo Zhuang, a China economist at London research firm Trusted Sources, told Bloomberg:
“It’s quite an alarming issue. The government is trying very hard to slow down the pace of the leveraging up, but they are not deleveraging. The debt-to-GDP ratio will continue to go up.”
If you’re concerned with what will happen if China’s debt gets out of control, then you deserve a gold star.
What Happens If the Debt Bubble Pops
Consider what would happen if Chinese economic growth were to slow so much that borrowers in the country began defaulting on their debt en masse.
First, that would ignite a vicious cycle of Chinese debt collapse that would begin to really slow the domestic Chinese economy. That slowing, if sufficiently severe, would cause a spike in non-performing loans on banks’ balance sheets.
Already, Chinese banks appear to be loosening their stance on bad loans. According to ratings agency Moody’s Investors Service, many Chinese banks are “failing to include some debts that have been overdue for at least 90 days.”
A spike in non-performing loans would put huge pressure on Chinese financial stocks, many of which comprise the benchmark iShares China Large-Cap ETF (FXI).
This widely held exchange-traded fund includes stalwart Chinese stocks such as China Construction Bank (CICHY), Industrial and Commercial Bank of China Limited (IDCBY) and Bank of China Limited (BACHY).
In fact, nearly half of FXI’s component holdings are in the financial sector. So, it is easy to understand how a plunge these stocks could infect the entire large-cap segment of the Chinese stock market, and that, by extension, could hit the entire global equity market with big selling.
In August, we witnessed what can happen when China growth fears morphed into a lack of confidence in policymakers to “fix” the country’s fiscal problems. The devaluing of the yuan and the subsequent stimulus and bank loan easing that followed all are attempts at keeping the second-largest economy in the world growing at the target rate.
But what happens if China’s overall debt load proves a raging elephant too big for any policymakers to deal with?
One outcome is global equity contagion — and even possibly the beginning of the next global recession.
As of this writing, Jim Woods did not hold a position in any of the aforementioned securities.