China’s Ticking Debt Bomb

Lower economic activity affects everyone. China is also built on debt which could implode, what then?

Knowledge @ Wharton
16 April 2014

Last month, China witnessed an historic moment — but not one that’s an obvious cause for celebration. When it failed to meet interest payments on its bonds, Shanghai Chaori Solar Energy became China’s first domestic corporate bond default. Soon after, Shanxi Haixin Iron and Steel Group Co., Ltd., defaulted on bank loans. The defaults should not have come as a surprise, since both companies operate in industries suffering from overcapacity. But in a country where the government often steps in to keep economic enterprises in key sectors afloat, the defaults signaled a change in direction. Premier Li Keqiang said during a March press conference that other defaults are “unavoidable.”

Amid predictions that China’s GDP growth rate will slow to 7.5% this year (also the government’s official target rate), Morgan Stanley suggests in a recent report that China will soon be meeting its “Minsky Moment,” or a “disorderly unwind” of private sector and local government debt. High rates of investment, fueled by borrowing, stand now at more than 45% of GDP and contributed 80% of China’s growth over the last 10 years, according to the World Bank. But as those investments grow, the return on them is declining — taking four renminbi of investment to produce 1 RMB of GDP today, compared to a 1:1 ratio in the early 2000s, according to Morgan Stanley. As it becomes harder for borrowers to make money to pay back their loans, Morgan Stanley predicts that China’s GDP growth could slow to 4% in two years, dampening global economic growth enough “to cause a global earnings recession.”

By the Minsky Moment, Morgan Stanley refers to economist Hyman Minsky’s framework identifying three scenarios for an economy: Hedge finance, where borrowers have enough cash flow to pay both interest and principal on their debt; speculative finance, where borrowers have the cash flow to pay only interest and must rollover their debt; and Ponzi finance, where borrowers can’t pay interest or principal and must borrow more or sell assets just to pay interest. The Minsky Moment comes when borrowers can no longer roll over their loans or borrow to pay their interest — often occurring at the same time as the central bank is tightening credit to combat inflationary pressures.

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