One would think that an important lesson would have been learned following the crisis of 2008. In many western countries large buildups in debt allowed for wild spending to occur in the wake of the dot-com bust. Unfortunately, this leverage proved to be the Achilles heel of the economy as the interest payments on these bills became too much to bear.
Many countries did learn an important lesson and have allowed their banking system to be cleaned up (i.e., shrunk) to sustainability. Leverage has decreased, and many homeowners found out the hard way that buying an asset depends on one's ability to pay for it upfront – or at least continuing to pay down the mortgage after the fact.
China today offers many parallels to the Western world of five years ago, and in many ways has gone in excess of anything European or North American countries were capable of. Consider the following stylized facts of China's present financial system.
Overall credit in the Chinese economy has increased to $23 trillion from $9 trillion since 2008.
The level of credit is now over 200% of GDP, an increase of 75 percentage points in the past five years. By way of comparison, during the five-year period before the United States' subprime bubble burst, this ratio increased by about 40 percentage points.
The credit-rating agency Fitch recently downgraded China's government debt to AA-.
By all measures, credit growth is rampant. The most damning figure, though, is the cost of borrowing. Much of this debt is of short term and, as such, needs to be continually "rolled over" for financing.
By way of example, consider a construction company building a new investment. The company needs to secure funding for 10 years, the expected duration of the project. Ten-year funding is costly, so the firm borrows what it needs for six months and then at the end of that period will just re-borrow the funding for another six-month period. This re-borrowing is called "rolling over" a loan.
The threat with such financing is two-fold. On the one hand, if interest rates rise then it becomes more costly for the firm to roll over its debt. On the other hand, imagine what would happen if there was no counterparty willing to extend credit when necessary.
After the collapse of Lehman Brothers in the United States, a similar problem was endemic. In my book, Deep Freeze: Iceland's Economic Collapse (co-authored with Philipp Bagus), we explained how it was possible for the Icelandic economy to freefall so completely and quickly.
In short, the situation was completely analogous to the Chinese one of today. Over-leveraged banks were dependent on continually rolling over their short-term debts. When Lehman went bust and financial firms retrenched, there were few lenders to be found because all the major financial companies were either trying to recapitalize themselves or were weary of extending credit to others until it could be determined who was credit-worthy.
A good way to gauge the ease of rolling over debt is by looking at the repo market. The seven-day repo rate in Shanghai surged to a record high of 10.77 % this week, the highest since March 2003. The one-day rate hit 12.85 %, and Zerohedge reported that the overnight repo market was demanding as high as 25% interest.
Such high rates are indicative of a liquidity squeeze, similar to what occurred in late 2008. Many firms scrambling to secure short-term funding are finding intense competition for the scarce funds. Those that are able to secure it have to pay crippling double-digit interest rates.
Consider the real problem involved with these high rates: companies embark on time-consuming investments that will only pay out until some future date. To pay their wages, materials, electricity and other bills, they must secure some type of financing in the present. Short-term loans, once so plentiful, were the preferred type. They were also cheap due to the perceived profitability of the Chinese "investments."
The true state of some of these investments is now becoming apparent. Construction has been the main driver of growth over the past few years, accounting for as much as 20% to 30% of the entire economy.
The country has built between 12 and 24 cities a year, complete with homes and facilities for millions of new citizens. The only problem is that there are no buyers, because no one wants to live in these cities or can afford to do so.
These projects, financed with short-term credit, are now obvious as the unprofitable undertakings they always were. The jump in interest rates is indicative of the past errors of these investments.
China's looming bust is a typical case of a credit-fuelled boom. The old adage says that the bigger they are, the harder they fall. No one has built bigger or faster than the Chinese have over the past 10 years. Time will have to tell if they will also fall faster and harder than anyone before them. •
