How Long Can China's Debt Continue To Grow Before A Systemic Crisis Strikes?

Nearly three years ago, Morgan Stanley may have jumped the shark (a little) when its strategists Cyril Moulle-Berteaux and Sergei Parmenov declared that China's Minsky Moment has arrived. While that may have been partially true, the fact that China managed to incur an additional $12 trillion in total debt in the interim period, suggests that Beijing at least managed to postpone the inevitable.

And since in the 3 years since little has changed, questions about how much longer the Chinese debt-fueled growth "farce" can continue have once again emerged, in their latest incarnation courtesy of UBS, whose economist Tao Wang asks "How long can debt continue to grow before a Minsky moment or systemic debt crisis?"

Here is the proposed answer:

However, while a conventional debt crisis may be avoidable, UBS admits that ever-rising debt is problematic even if problems do not manifest themselves in a crisis.

The fact that debt is rising much faster than output year after year and an increasing share of debt is allocated in nonproductive or excess capacity sectors means misallocation of resources. Such systematic misallocation will depress long term productivity and economic growth, and wasted resources mean more potential bad debt will be created. While the aforementioned unique factors can allow China's credit cycle to last much longer than in other economies and with less volatility, this lack of a market-clearing mechanism could depress corporate profitability and investment, leading to lower or stagnant economic growth over a prolonged period of time. Eventually, the cost of accumulating so much bad debt will have to be borne by the financial sector and savers, asset prices will have to correct, and the ultimate cost of adjustment may be substantially larger.

How will this debt cycle play out and what to watch?

So while on net UBS is not yet sounding the alarm on the imminent bursting of the world's biggest debt bubble, here are the four warning signs investors should watch for when it comes to China: 

1. Liquidity (LDR) in the broad banking system after adjusting for shadow credit;
2. change in profit margins and/or return on assets in the corporate sector;
3. size of shadow credit relative to traditional banking; and
4. net capital outflows – persistent large outflows will erode China's domestic liquidity buffer.