Could China find itself at the centre of the next financial crisis because of its mounting debt?
China has been a force of stability in recent financial downturns, but may play a different role in future crises, analysts said.
Ten years ago on Saturday, the investment bank Lehman Brothers Holdings collapsed overnight into bankruptcy as the global financial system teetered on the brink of ruin.
It marked a pivotal week that saw the US government move in to save the insurance giant American International Group and issue a massive bailout to America’s banks. The major US indexes lost 4 per cent of their value and long-time names on Wall Street, including Merrill Lynch, were absorbed into other banks in the coming days.
The contagion spread to other parts of the world and the ensuing financial crisis, sparked by a collapse in the US housing market, ultimately destroyed US$34.4 billion in wealth globally when equity markets hit their lowest point in March 2009, according to the Roosevelt Institute, a US think tank.
China did not suffer the same kind of extended malaise that plagued many of the world’s economies and recovered at a much quicker pace than the United States and Europe. Much like it did during the Asian financial crisis a decade earlier, China served as a stabilising force amid the turmoil.
However, China’s role in the next financial downturn may be a very different one as its level of borrowing has grown dramatically in the past decade and its economy continues to evolve, analysts said.
Haibin Zhu, J.P. Morgan chief China economist, said that China’s debt is a “key source of vulnerability,” even though much of it is domestic and owned by the country’s public sector.
“Given the size of the economy and of the debt burden, and the extensive cross-border financial connections, a disruptive debt event in China could quickly spread to other parts of the globe,” Zhu said in a research report. “That is, China could well be the epicentre of the next crisis.”
China accounted for 43 per cent of the increase in worldwide debt since 2007, with global debt standing at US$164 trillion in 2016, according to the International Monetary Fund.
Its ratio of credit to the non-financial sector as a percentage of gross domestic product, an important measure of debt levels, stood at 208.7 per cent at the end of last year, up from 115.6 per cent at the end of 2007, according to the Bank of International Settlements.
By comparison, the credit-to-GDP ratio for the United States was 152.2 per cent and 159.7 per cent in the euro zone at the end of last year, according to BIS.
Much of that growth has come in the form of “shadow banking,” or lending by entities other than banks, since the financial crisis. These range from large trust companies to peer-to-peer lenders and micro-financing firms.
“The rapid growth in China's shadow banking system has occurred largely because the traditional banking system could not meet the strong growth in demand for funding after the [global financial crisis] because of regulatory constraints,” the Reserve Bank of Australia said in a report in March.
The Financial Stability Board estimates that entities other than banks, insurance companies, pension funds and other public financial institutions in China accounted for US$9.6 trillion in assets at the end of 2016.
The rating agency Standard & Poor’s said that non-banks contributed to over 40 per cent of the increase in debt in China in the years following the financial crisis and now account for more than 25 per cent of the country’s overall debt.
Chinese authorities have moved to rein in shadow banking as part of an overall effort to decrease debt levels in the country following years of easy money.
Henry Chan, the head of research at Caitong International Securities, said that the concerns about China’s debt levels are overblown, particularly when compared with other major economies.
He noted that there remains a shortage of housing in China, which has driven prices higher and led to increased debt levels rather than representing a bubble in the market.
“Those perverted minds who have trumpeted Chinese doom for years without success have no knowledge of supply and demand of housing,” Chan said. “The next debt crisis will likely happen, but not in China. It will happen when prices of crude oil, natural gas, coal rocket further.”
In the weeks following the Lehman bankruptcy in 2008, China had to move quickly to stave off the effects of the global slowdown as it faced one of the largest collapses in trade since the Great Depression. The Chinese government injected some 4 trillion yuan (US$582 billion) into the economy.
As a result, the Chinese economy avoided a recession and recovered more quickly than other major economies, according to Yi Wen and Jing Wu, researchers for the Federal Reserve Bank of St. Louis.
“Thanks to sharp increases in aggregate investment immediately following the money injection, the Chinese economy rebounded quickly to its pre-crisis level and successfully prevented a possible Great Recession and economic collapse during China’s critical period of economic transition and industrialisation,” the researchers said in a report last year. “Consequently, China emerged after the crisis as the world’s number one manufacturing powerhouse and the only significant engine of global economic growth.”
In the years since the crisis, regulators world have enacted reams of new rules designed to limit the risks banks can take, increase the level of capital they are required to hold and protect depositors in a potential collapse.
Central banks also have kept interest rates at record lows and engaged in years of bond-buying programmes known as quantitative easing to stimulate economies in the aftermath of the global financial crisis.
Banks and other financial firms have significantly strengthened their balance sheets and regulators have move to create “a more robust financial ecosystem,” but there are some concerns what tools are available to combat a downturn in the near future, the Depository Trust & Clearing Corporation said.
“The public sector is left with less ammunition than it had a decade ago,” DTCC said in a white paper released this week. “Over the past decade, central banks around the world have conducted quantitative easing programmes on an unprecedented scale, pushing interest rates down – in some cases into negative territory – while amassing multi-trillion dollar balance sheets in the process. While these programmes have been remarkably successful so far, both in terms of addressing the impact of the financial crisis and controlling inflationary risks, they have undeniably left central banks with less latitude to combat another crisis.”
While much attention has been paid to the level of debt in China, rising debt levels globally in recent years have some observers concerned about what rising interest rates will mean for borrowers and the ability of the financial system to absorb the debt that had been bought by central banks to stimulate the world’s economies.
“If it is actually possible to withdraw the previous 10 years of stimulus without causing the next crisis, then we are about to find out whether [quantitative easing] is the de facto new policy tool of central banks to be used in the future,” Nick Clay, lead manager of the BNY Mellon Global Income Fund in London, said.
“If, however, [quantitative tightening] exposes the unsustainable nature of this addiction, then we will realise we have learned nothing,” he said. “We believe this is the more likely outcome, and already this year we have witnessed an entire opera of canaries beginning to sing in the coal mine, ranging from low volatility funds imploding to Turkey’s current travails.”
Weakness in emerging market economies and an escalating trade war between the US and China also have raised concerns about when the next major financial downturn may come.
The trade war is already putting pressure on markets dependent on the flow of trade between China and the US, with the Shanghai Composite Index down by 25 per cent from a high in January and Hong Kong’s Hang Seng Index sliding into bear territory this week.
The MSCI Emerging Markets Index separately fell into bear territory last week, a sign of increasing concern in markets about the economies of less developed countries.
Adarsh Sinha, co-head of Asia rates and foreign exchange strategy at Bank of America Merrill Lynch in Hong Kong, said the slowdown in emerging markets is a problem, but not on the scale of the 2008 global financial crisis, or the 1998 Asian financial crisis.
“Given that the buffers have been strengthened after 2008, it makes it less likely that you see the depth of the financial crises that we’ve seen in the past, at least over the next several years given what the economic backdrop looks like,” Sinha said.