Many longtime readers know that I’ve remained skeptical about China’s economy for a couple years now.

And while the mainstream financial media hasn’t worried much over China’s economic future – I still do.

That’s because China’s growth is extremely important to the global economy (especially since 2008). It has more-or-less carried the global economy.

Pixabay

(Note that via the ‘locomotive effect’ –  a key theory in macro-economics – China’s economy surpassed the US as the marginal growth engine post-2008. Meaning: due to China’s economic scale and above-trend growth – their boom-bust cycles carry the world along with them).

But – after years of binging on cheap debts, an over-reliance on investment driven projects with steadily diminishing returns, and a rapidly aging population – China’s economy has grown increasingly fragile.

Thus – putting it simply: I believe that China’s economy has grown very out-of-balance. And is approaching a deflationary tipping-point – much sooner than many realize.

Let me explain. . .

Due to more than a decade of easy-money – thanks to global central banks – global governments and firms binged on cheap debt (especially the emerging markets).

And thus – 11-years later – China’s debt levels have soared to the highest among major emerging markets. . .

And to make matters worse – it now seems as if China’s domestic debt-load has hit a point where it can no–longer be safely sustained by simply ‘rolling-over’ maturing debts (aka refinancing).

For instance – in just the first five months of 2021 – Chinese firms have already missed 99.8-billion-yuan ($15 billion) worth of on-shore bond payments. (And defaults on off-shore dollar-denominated bonds have also soared $4 billion in the first 3-months of 2021 – already half of 2020’s total).

Now – not only is this the largest missed balance on record. But it’s also the fourth year straight with Chinese firms defaulting on at-least 100-billion-yuan worth of bonds. . .

And while most of these defaults (over >25%) were from real estate and property development firms – it appears things will only grow increasingly fragile for the overly-indebted sector as Chinese authorities further restrict access to credit. (Meaning: at a time when real estate and property firms need easy money to refinance old debts – they’re being cut off).

In fact – this brings us to the largest issue facing China’s leveraged economy. . .

Simply put: the Chinese authorities have grown worried about domestic debt-burdens, asset bubbles, shadow banking, and excess speculation. Thus – they have recently adopted tighter financial policies to try and limit such risks. (Aka they’re trying to slowly deflate asset bubbles and deleverage enough before a black swan event occurs).

And we’re already seeing this financial ‘tightening’ happen. . .

For instance – a report in April showed that the People’s Bank of China (aka the PBoC – China’s central bank) told both domestic and foreign banks to keep curb any significant new lending in 2021.

To put this in context: if banks listen to the PBoC and lend at roughly the same rate as they did last year – it would cause credit growth to slow to a 15-year low. . .

But – what’s more dire is that China’s six-and-twelve-month ‘credit impulse’ – a key leading indicator that measures the change in new credit issued as a percentage of GDP – are now both negative.

(Note that – historically – China’s credit impulse has signaled the onset of both booms-and-busts for economic growth and various asset classes. And since China’s now the global growth engine – when they sneeze, the whole world catches a cold).

The most significant thing about this decline in the credit impulse was how fast it happened. It took just seven-months to go from peak-to-negative – much less than previous cycles).

So – what does this mean?

Well – this indicates that China’s economy may slow significantly over the coming quarters, and could last until mid-2022. (And down along with it – the demand for major commodities).

Or – putting it another way: because of tighter credit polices in China – bond defaults may increase at a time when growth slows. Thus greatly increasing negative tail risks (aka black swan events) and the chance of triggering a wave of deflation across the world. (China consumes a huge amount of energy and commodities – thus any slowdown would negatively effect those sectors).  

So – in summary – China’s economy is far more fragile than the mainstream financial media lets on.

Years of easy money allowed the Chinese economy to grow aggressively – letting firms binge on cheap debt.

But – as we’ve seen time and time again – once credit begins tightening, downside risks significantly grow.

(Note that Chinese firms were already struggling with souring debts years before any tightening. So I imagine it will only get worse going forward).

Keep in mind that China’s situation is eerily similar to Japan’s from the 1980-90’s.

Like China today – Japan built up it’s economy by focusing on its export sector and domestic investment projects (malls, apartments, infrastructure, etc).

And during the boom years – Japan’s economy also greatly expanded credit – allowing domestic firms to pile on cheap debt.

But overtime – as credit tightened – a large portion of these investments and debts soured.

Adding salt to the wound – asset prices and investment driven returns also plunged. Causing creditors and banks to suffer deep losses – thus triggering credit downgrades. Which made it more difficult for debtors to raise funds.

And on and on. . .

Eventually – Japan had to endure (to this very day) a multi-decade deflationary bust because of all the enormous deleveraging that needed to happen.

Now – is China just like Japan? No. So it doesn’t mean there’ll be a repeat crisis.

But it’s important to note the similarities. And that historically – extended periods of credit expansion almost always come at a hefty price. . .

As of today – it remains to be seen if the US economy (which’s been fueled by significant liquidity) can grow enough to off-set China’s tightening. (Not to mention the global post-COVID boom that’s ongoing doesn’t hurt).

But – still– I believe China’s economy is nearing a tipping-point. Especially as more and more debts reach maturity while credit growth tightens (creating stress).

And any slowdown in China would most likely trigger a wave of unintended consequences throughout the global economy and financial system.

Well – only time will tell.

PS – I highly recommend these two underrated books on China’s fragile economy. ‘The Great Rebalancing’ by Michael Pettis + ‘China: The Bubble That Never Pops’ by Thomas Orlik