Domestically China has gone through an investment and borrowing boom that has left companies with mountains of debt and Chinese banks with mountains of bad loans. Standard and Poor’s (S&P) estimates that China’s nonfinancial companies have outstanding loans of $14.2 trillion dollars with projected growth of this debt to $20 trillion dollars in 2018. This amounts to one third of world corporate borrowing. Comparatively, US companies have outstanding loans of $13.1 trillion dollars.
A driving factor in the ability to pay off a loan is the interest rate on the money borrowed. The base interest rate in China was lowered through a series of six rate cuts from 6% to 4.35% in 2015. However, inflation has dropped from 2.5% to 1.3%. This combination makes the decrease in real (inflation adjusted) rates far less meaningful for corporate China. In fact it is estimated that the real interest rate for Chinese companies is a crushing 12%. (Thomas, 2015)
The problem with too much debt is not just that it constrains growth, it can precipitate a crisis. China’s corporate and governmental debt is inverted, meaning that its debt load is increasing at a faster rate than its ability to pay off this debt. If China’s balance sheet were a credit card, the overall balance and minimum payment due is increasing at the same time that China’s economic growth is slowing. In other words, the bills are piling up and the ability to pay those bills is decreasing. This inverted structure systematically enhances volatility making the good times great but also making the bad times worse. (Pettis, 2015)
China is trying to shift its economy from an export-based economy to one driven by consumption. The US economy is a consumption style model and the key to wealth creation for the US consumer is the US housing market. In China, the housing market is so thin (lacking both buyers and affordable space) that you have examples of ‘irrational exuberance’ such as a 300 square foot Shanghai apartment going for $3.5 million. (Zeihan, 2015) There simply isn’t a housing market with the breadth or depth to help create a consumer class in China. A long-term consumer wealth creation engine is sorely missing in China.
Another worrying sign that China’s economy is deteriorating rapidly was the 3% currency devaluation on August 11th, 2015. This devaluation indicated that economic transition from an export led economy to a consumption based economy is not going as planned. China devalued its currency to make exports less expensive and stimulate industrial sales to foreign buyers. This move was interpreted by its neighbors as an act of economic war. Vietnam, Philippines and Indonesia followed suit and devalued their currencies to stay competitive. Globally, stock markets dropped over 6% in August 2015, creating global criticism of China’s currency manipulation.
As a result of the currency wars and to stave off another devaluation, China, the largest holder of US Treasury bonds, reduced their holdings to the lowest level in seven months, $1.258 trillion dollars. This $327 billion decrease was due to China’s defense of the yuan (selling dollars to buy yuan therefore strengthening the price of the yuan). (Trivedi, 2015) Devaluation, slowing growth and unhealthy levels of debt all point to a Chinese economy that is rapidly crumbling.