A China Prediction: A Debt Deleveraging in a Decade

“What happens when torrid monetary and fiscal reflation in the West meets tighter credit and evaporating liquidity in China?

We will find out soon enough who calls the shots for world inflation in a globalised economy dominated by cross-border capital flows. We will also find out whether these two colliding forces moderate each other, or set off the sort of wild ructions in currency, commodity, and bond markets that make hedge funds salivate.”

-Ambrose Evans-Pritchard, “The world’s reflation party may be spoilt by China hitting the brakes.” The Telegraph. May 27, 2021.

There’s an interesting dynamic at play with coverage like the above. What most people miss, because they have attention spans of this quarter or this year, is that China has been doing torrid monetary and fiscal reflation for years, and the attendant moral hazard of having free money guaranteed by the government is starting to show how much systemic risk is hidden from view in China.

If you look at a standard breakdown of debt to GDP, like this one from Trading Economics, China looks to be in a very good position relative to the rest of the world. For China, the ratio is 66.8%, below India’s 69.6%. For the United States, it’s 108%. Now, consider this table from SPGlobal’s March report: Local Government Debt 2021: China’s Dominance Overshadows Borrowing Capacity In Other Emerging Markets.

Notice how much China’s subnational borrowing is compared to India’s? This explains why China’s national borrowing looks so good relative to other “developing” countries. They are, once again, cooking the books.

China has been doing torrid monetary inflation for years, but keeping it off the national books and putting it onto local government debt. And, it has been long understood that local government debt, partnerships and so forth were essentially backed by the national government, which means they are essentially national debt. If those numbers were added to reflect this reality, China’s debt to GDP would be worse than the United States.

So, they’ve reached the point of moral hazard, where they have to decide whether they are going to allow for defaults, bankruptcies and the restructuring of debt. To their credit, they are making some inroads on this front, but articles like the one above are hilarious because it fundamentally misunderstands this central point. China is slowing down because they have been using these policies for decades, whereas Western governments quantitative easing and other measures of pushing liquidity into markets were done in response to the 2008 financial crisis. Like China, Western markets have grown dependent on this influx of cash.

But, obviously, there’s going to be a reckoning, and the funny thing is that reckoning is going to begin in China and then eventually spread to the rest of the world. Whether it will happen in close proximity to the end of the COVID-19 pandemic remains to be seen, but there is definitely a short term correction and a longer term debt cycle deleveraging that are being put off by these policies. At some point, it will no longer be able to be kept at bay. If you want more detail, Ray Dalio’s talk on How The Economic Machine Works is a good point of reference.