Bloomberg News finally did something useful this morning by publishing some startling graphs from McKinsey’s latest update on the worldwide debt tsunami. If you don’t mind a tad of rounding, the planetary debt total now stands at $200 trillion compared to world GDP of just $70 trillion.
Consequently, when Keynesian economists jabber about “stimulating” or “recovering” putatively lost “aggregate demand” they are talking about an economic unicorn. Aggregate demand can only be accelerated beyond production by new borrowing, and that can’t happen when balance sheets are tapped out.
Needless to say, Greece is only the poster child. The McKinsey numbers above suggest that “peak debt” is becoming a universal condition, and that today’s Keynesian central bankers and policy apparatchiks are only pushing on a giant and dangerous global string.
Moreover, bad as this is, its only half the story. Not only do unsustainable debt booms eventually stop, as depicted in Greece GDP accounts above, but they also generate enormous deformations and malinvestments while they are inflating. That is, they cause economic waste in the form of capital investments which are latter written down or abandoned because they do not produce sufficient returns to cover their front-end financing cost; and they also result in the allocation of labor to activities and occupations that disappear when the debt boom ends, generating unemployment and skill redundancy that lowers output and efficiency.
In Greece’s case, its debt binge got up a full head of steam at the time of the 2004 Summer Olympics in Athens. I was there that summer and marveled at the skyline of construction cranes, the oppressive din of jackhammers and the bustling constructions sites that were so numerous and expansive that traffic had virtually ground to a halt.
The Greek government spent something like $15 billion on the Olympics, but that was just the tip of the iceberg. With cheap euro denominated debt literally falling from the northern skies of the French and German banking system, there was no end to the commercial construction of hotels, retail, offices and apartments designed to feed on the alleged multiplier effect of the Olympics and the belief that they were a catalyst for permanent growth.
Below is an epigrammatic picture of the 2004 Olympics boom today. In a narrow sense, the whole boom was a debt fueled national vanity project that is not atypical of these promotional event schemes. But it illustrates a crucial point that has universal application in today’s global financial Ponzi. Namely, that the value of assets generated during the debt boom can shrink drastically or disappear entirely after the party ends if they do not produce useful services and a commensurate cash flow.
By contrast, the debt is fixed and contractual until its is written off and holders of the paper take a current loss. Upon that liquidation event, of course, balance sheets shrink and paper wealth evaporates. That’s why debt booms are inherently and ultimately deflationary.
Needless to say, the abandoned multi-million dollar Athens stadium pictured below is worth nothing, yet the debt which funded it has not been liquidated. It still hangs somewhere in financial hyperspace—- having been transferred by the EU superstate politicians and bureaucrats from the accounts of the banks or bond investors which originated the funding to Greece’s make pretend IOU accounts at the IMF and EU.
Call this financial constipation—-the end result of the current global game of “extend and pretend”. It amounts to a financial Ponzi in which current debt is serviced with more debt, and in which the unsustainability of the entire edifice is obfuscated by the zero interest rate policies and massive debt buying campaigns of the world’s central banks.
When bad debts are not liquidated—– we already know that you get a Greece calamity with $350 billion of debt that cannot possibly be serviced or repaid by its now ruptured economy. But what will only become evident with time is that the entire global economy is not too far behind. It is now burdened with $200 trillion in debt, but owing to debt-bloated GDP, its true leverage ratio, like that of Greece in 2009, is far higher than the 2.9X computed in the McKinsey charts above.
So now we get to ground zero of the global Ponzi. That is the monumental pile of construction and debt that is otherwise known on Wall Street as the miracle of “red capitalism”. In truth, however, China is not an economic miracle at all; its just a case of the above abandoned Athens stadium writ large.
The McKinsey graph on China tells it all. For the moment, forget about leverage ratios, debt carrying capacity and all the other fancy economic metrics. Does it seem likely that a country which is still run by a communist dictatorship and which was on the verge of mass starvation and utter impoverishment only 35 years ago could have prudently increased its outstanding total debt (public and private) from $2 trillion to $28 trillion or by 14X in the short span of 14 years? And especially when half of this period encompassed what is held to be the greatest global financial crisis of modern times
And don’t forget that most of this staggering sum of debt was issued by a “banking” system (and its shadow banking affiliates) which is bereft of any and every known mechanism of financial discipline and market constraints on risk and credit extension. In effect, it is simply a vast pyramidal appendage of the Chinese state in which credit is conjured from thin air by the trillions, and then cascaded in plans and quotas down through regions, counties, cities and towns.
When it reaches its end destination it finances the building of anything that local politicians, bureaucrats and red capitalists can dream up. That includes factories, roads, ports, subways, bridges, airports, malls, apartments and all the rest of the construction projects being undertaken on Beijing’s Noah’s ark.
Undoubtedly, the plentitude of ghost cities, malls, apartment buildings and factories that are everywhere now evident in China do not look much different than Greece’s Olympic stadiums did circa 2006—-that is, gleaming but silent. It will take another decade for the weeds to spring up and the rust and decay to become visible.
So it might be a good time to get a grip on the China Ponzi. There is virtually not a single honest price in the entire $28 trillion tower of debt shown below. When loans to coal mine operators got in trouble, for example, the so-called “bankers” at the big state banks simply invited their clients in the side door where they paid back the “bank” with a trust loan at 18% interest—-which “loan” was then resold to bank customers at 12%.
Hence, no NPLs and no need for new loss provisions. Indeed, China’s big state banks book billions of profits each quarter—notwithstanding the absurd extent of the nation’s credit pyramid.
Likewise, how did the local party cadres use the loans that cascaded down the system to their town? Why they established non-governmental development agencies—thousands of them—- that paid hugely inflated prices for city lands in order to build empty luxury apartments and zoos that are bereft of both people and animals. Meanwhile, local governments run huge GDP enhancing budgets that are funded by the false revenue of hyper-bloated land sales.
The skunk in the woodpile is self evident even in the simplified chart below. At least prior to the 2008 crisis, it could be said that part of the China boom was being financed by the Fed and other DM central banks which enabled their domestic consumers to borrow themselves silly, thereby fueling the China export boom. That’s pretty much over in terms of growth owing to the tepid recoveries and outright economic stagnation in the US, Europe and Japan.
But never mind. The aging black-haired men who learned their economics from the Mao’s Little Red Book had a solution. They would lift GDP and jobs by their own bootstraps, dispensing virtually unlimited credit to build public pyramids, otherwise known as infrastructure, at rates not seen since the Egyptian pharaohs.
Thus, since the eve of the crisis in 2007, China’s GDP has doubled, expanding by $5 trillion in 7 years. But as shown below, it took a $21 trillion expansion of debt outstanding to accomplish that outcome.
That’s right. The China Ponzi took on $4 of debt for every new dollar of freshly constructed GDP. And “constructed” is exactly the correct term because all of this new debt funded a orgy of construction—-much of which is for public facilities that will never produce enough user revenues to service the debt or which are essentially owned by local governments which have no tax revenue.
China is trapped. The Communist authorities have discovered, like the Japanese in the early 1990s and the US in the inter-war years, that they cannot deflate a credit bubble safely.
A year of tight money from the People’s Bank and a $250bn crackdown on shadow banking have pushed the Chinese economy close to a debt-deflation crisis.
Wednesday’s surprise cut in the Reserve Requirement Ratio (RRR) – the main policy tool – comes in the nick of time. Factory gate deflation has reached -3.3pc. The official gauge of manufacturing fell below the “boom-bust” line to 49.8 in January.
Haibin Zhu, from JP Morgan, says the 50-point cut in the RRR from 20pc to 19.5pc injects roughly $100bn into the system.
This will not, in itself, change anything. The average one-year borrowing cost for Chinese companies has risen from zero to 5pc in real terms over the past three years as a result of falling inflation. UBS said the debt-servicing burden for these firms has doubled from 7.5pc to 15pc of GDP.
Yet the cut marks an inflection point. There will undoubtedly be a long series of cuts before China sweats out its hangover from a $26 trillion credit boom. Debt has risen from 100pc to 250pc of GDP in eight years. By comparison, Japan’s credit growth in the cycle preceding its Lost Decade was 50pc of GDP.
The People’s Bank may have to cut all the way to zero in the end – a $4 trillion reserve of emergency oxygen – but to do that is to play the last card.
Wednesday’s trigger was an amber warning sign in the jobs market. The employment component of the manufacturing survey contracted for the 15th month. Premier Li Keqiang targets jobs – not growth – and the labour market is looking faintly ominous for the first time.
Unemployment is supposed to be 4.1pc, a make-believe figure. A joint study by the International Monetary Fund and the International Labour Federation said it is really 6.3pc, high enough to cause sleepless nights for a one-party regime that depends on ever-rising prosperity to replace the lost elan of revolutionary Maoism.
Whether or not you call it a hard-landing, China is struggling. Home prices fell 4.3pc in December. New floor space started has slumped 30pc on a three-month basis. This packs a macro-economic punch.
A study by Jun Nie and Guangye Cao for the US Federal Reserve said that since 1998 property investment in China has risen from 4pc to 15pc of GDP, the same level as in Spain at the peak of the “burbuja”. The inventory overhang has risen to 18 months compared with 5.8 in the US.
The property slump is turning into a fiscal squeeze since land sales make up 25pc of local government money. Zhiwei Zhang, from Deutsche Bank, says land revenues crashed 21pc in the fourth quarter of last year. “The decline of fiscal revenue is the top risk in China and will lead to a sharp slowdown,” he said.
The IMF says China’s fiscal deficit is nearly 10pc of GDP once land sales are stripped out and all spending included, far higher than generally supposed. It warned two years ago that Beijing was running out of room and could ultimately face “a severe credit crunch”.
The gears are shifting across the Chinese policy spectrum. Shanghai Securities News reported that 14 Chinese provinces are preparing a $2.4 trillion blitz on infrastructure to combat the downturn, a reversion to the same policies of reflexive stimulus that President Xi Jinping forswore in his Third Plenum reforms.
How much of this is new money remains to be seen but there is no doubt that Beijing is blinking. It may be right to do so – given the choice of poisons – yet such a course stores up even greater problems for the future. The China Development Research Council, Li Keqiang’s brain-trust, has been shouting from the rooftops that the country must take its post-debt punishment “as soon possible”.
China is not alone in facing this dilemma as deflation spreads and beggar-thy-neighbour currency wars become the norm. Fifteen central banks have eased monetary policy so far this year.
Denmark’s National Bank has cut rates three times in two weeks to -0.5pc in an effort to defend its euro-peg, the latest casualty of the European Central Bank’s €1.1 trillion quantitative easing. The Swiss central bank has been blown away.
Asia is already in a currency cauldron, eerily like the onset of the 1998 crisis. The Japanese yen has fallen by half against the Chinese yuan since Abenomics burst upon the Pacific Rim. Japanese exporters pocketed the windfall gains of devaluation at first to boost margins. Now they are cutting prices to gain export share, exporting deflation.
China’s yuan is loosely pegged to a rocketing US dollar. Its trade-weighted exchange rate has jumped 10pc since July. This is eroding the wafer-thin profit margins of Chinese companies and tightening monetary conditions into the downturn.
David Woo, from Bank of America, says Beijing may be forced to join the currency wars to defend itself, even though this variant of the “Prisoner’s Dilemma” leaves everybody worse off. “We view a meaningful yuan devaluation as a major tail-risk for the global economy,” said.
If this were to happen, it would send a deflationary impulse worldwide. China spent $5 trillion on fixed investment last year, more than Europe and America combined, increasing its overcapacity in everything from shipping to steels, chemicals and solar panels, to even more unmanageable levels.
A yuan devaluation would dump this on everybody else. It would come at a moment when Europe is already in deflation at -0.6pc, and when Britain and the US are fast exhausting their inflation buffers as well.
Such a shock would be extremely hard to combat. Interest rates are already zero across the developed world. Five-year bond yields are negative in six European countries. The 10-year Bund has dropped to 0.31. These are no longer just 14th century lows. They are unprecedented.
My own guess is that we would have to tear up the script and start printing money to build roads, pay salaries and fund a vast New Deal. This form of helicopter money, or “fiscal dominance”, may be dangerous, but not nearly as dangerous as the alternative.
China faces a Morton’s Fork. Li Keqiang has made it his life’s mission to stop his country drifting into the middle income trap. He says himself that the investment-led model of past 30 years is obsolete. The low-hanging fruit of catch-up growth has been picked.
For two years he has been trying to tame the state’s industrial behemoths, and trying to wean the economy off credit. Yet virtuous intent has run into cold reality. It cannot be done. China passed the point of no return five years ago.
Reprinted with permission from David Stockman’s Corner.