While concerns about China’s debt load, capital flows, and depreciating currency have been pushed to the backburner in recent months, perhaps facilitated by a welcome rebound in global inflation – perceived by markets and global central bankers that monetary policy is finally working – it is worth a quick reminder of how we got here.
First, a quick trip through memory lane to remind us how much has changed in just the past year.
In a note by Morgan Stanley’s Chetan Ahya released on Sunday, the strategist reminds us that a little more than a year ago, the global economy was facing intense disinflationary pressures. Global commodity prices were declining significantly and the slowdown in China and other major commodity-producing EMs had led to some concerns that it could pull developed markets into recession and drag inflation down along with it. At the same time, in China, producer prices fell by almost 6%Y and the regime change in its currency management approach meant that China was no longer absorbing disinflationary pressures from abroad.
And while this seems like a distant memory today, thanks to China which has played a pivotal role in driving the global inflation cycle – this time on the upside – as the cyclical recovery has both lifted China’s own inflation and transmitted it globally, here is how this happened: the recovery in China has been driven by yet another round of debt indulgence. Debt in China has grown by US$4.5 trillion over the past 12 months, by far the highest amount of debt creation globally as compared to US$2.2 trillion in the US, US$870 billion in Japan and US$550 billion in the euro area. Indeed, China on its own has added more debt than the US, Japan and the euro area combined.
While we have shown the IIF’s forecast of Chinese debt countless times in recent months, here it is once again to put China’s unprecedented debt expansion in context:
Furthermore, as we noted last week, for the first time Chinese domestic debt liabilities crossed the 200 trillion yuan threshold, just shy of $20 trillion. This has been driven primarily as a result of an exponential increase in Chinese corporate debt which has grown from $4.5 trillion in 2008 to over $17 trillion as of 2016, even as Chinese GDP growth has been cut in half from 12% to 6% as trillions in non-performing loans – by some estimates as much as 20% of total loans – clog up the debt-growth transmission machinery.
For now at least, the good news is that this debt creation has at least managed to stoke Chinese inflation, if not so much economic growth. The bulk of the debt creation in China has been diverted towards infrastructure and property markets. This push to domestic demand has provided an uplift to global commodity prices and China’s commodity-related producer price segments, as Morgan Stanley calculates. Higher commodity prices, alongside the improvement in demand, have begun to translate, albeit modestly, into the non-commodity segments of the producer price index.
Outside China, the rise in commodity prices is pushing headline inflation higher in DM too. Given China’s dominant role in the global manufacturing supply chain, the dissipating disinflationary pressures in China’s producer prices should transmit more generally into tradeables (core goods) inflation. Recall that while core services inflation had been holding up well in DM, it was the core goods component which had been the key drag on core inflation.
That said, China is already slamming the brakes (or at least trying) on debt creation as much of these trillions in new debt have found their way into China’s housing market, where prices are growing at a record pace, leading to concerns for Beijing of another out of control housing bubble (which in turn has sent Chinese car sales soaring as the local asset bubble jumps from one asset to another).
And since record debt is what catalyzed the rebound in global inflation, any possibility of a slowdown in China’s debt-creation is being carefully watched. As Morgan Stanley adds, to assess the potential for any overshoot in the cyclical recovery, the key indicator to watch in this context will be China’s property sales. Fundamentally, the economy is still facing the issues of over-investment and excess capacity, which policy-makers are resolving in a gradual approach. These factors point towards a bias that disinflationary pressures will reassert themselves once the effects of the stimulus fade.
Ultimately this all goes to a topic we have discuss frequently, most recently last month, namely China’s credit impulse, which boosts both the economy and inflation expectations in the 1-2 quarter after a massive debt injections, but subsequently leads to a contraction unless offset with even more debt. Schematically, this is shown in the following Goldman chart:
Whether China’s recent debt-fueled growth fades soon is a material issue for the Fed which is set to hike rates in just over a month, a hike which like in December of 2015 may come at a time when the Chinese credit impulse pulls sharply back and lead to the next global deflationary wave just as the US is further tightening financial conditions, leading to a sharp spike in the USD and a substantial decline in the Yuan.
Further, as an indication of how intertwined China’s economic fate is with the rest of the world’s, a senior Australian politician warned, just weeks after the continent celebrated a quarter century of growth without a recession that “China’s growing debt mountain poses a risk to Australia’s financial stability.”
As the FT summarizes, China is Australia’s largest trading partner, accounting for A$150 billion of two-way trade in 2015. Beijing is also an important foreign investor in Australia, leaving Canberra potentially among the developed nations most exposed to a Chinese downturn. China’s growing debt in its local government and state-owned enterprise sector were potential vulnerabilities that could end up having an impact on the continent, Scott Morrison, Australian treasurer, said in an interview with the Financial Times.
“We are not rose-coloured-glasses optimists about China,” Mr Morrison said. “We have a practical and real appreciation about what some of their vulnerabilities are.”
Australia’s warning on Chinese debt follows concerns expressed by the International Monetary Fund and others, including billionaire George Soros, who have warned that adverse shocks in China fuelled by its rising debt levels could spark contagion and hit countries with a high trade exposure to the country.
“I am not forecasting any change in China but we are very practically minded of the vulnerabilities and what that could convert into — but equally saying they have the capacity to manage it,” he said.
It is courtesy of China, and thus its debt creation, that Australia’s economy is growing at an annual rate of 3.3%, among the highest in the developed world, and has notched up a remarkable quarter of a century of growth without a recession. Surging exports to China have played a key role in enabling its economy to continue growing even during the financial crisis in 2008, when many other countries faltered. Growth has remained robust despite a slump in commodities prices over the past five years.
Should China, whose consolidated debt/GDP is now at or above 300%, feel truly compelled to slow down its debt creation, not just Australia but the rest of the world will feel the consequences.