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The Minsky Moment

One of the current obsessions of economists and strategists relates to the sustainability of China’s leverage trends. The issue started to itch in 2013 and it has now become impossible not to scratch. Indeed, the debt level is not only high but is also growing fast whilst the economy continues to slow down. Everyone is thus trying to figure out when China will experience its “Minsky Moment”. That would be the equivalent of the moment when a cartoon character (such as Looney Tunes’ The Coyote) runs off a cliff and keeps running for a while as if on solid ground, until hit by the sudden realization that it is on nothing but thin air, which sends it crashing to the ground.

Hyman Minsky (1919–96), an American economist, argued that economic crisis are recurrently fuelled by the irresistible and eventually fatal accumulation of debt by the non-government sector as the economic cycle evolves from trough to peak, thereby exacerbating cycles. His theory received significant attention on the back of the subprime mortgage crisis (of course not before) as reported in a good 2008 The New Yorker article.

In China, leverage has admittedly been subject to worrying trends

  • The country’s debt (as measured by government, non-financial corporates and household debt) as a proportion of GDP has increased from 160% to 260% in just six years

  • That debt level is expected to increase by another c.15% in 2016 (roughly twice the speed of GDP) and may reach 300% of GDP by 2020

  • An increasing share of new debt has been used to help service existing debt (including by the so-called “zombie” companies, a term which is not new as it became already fashionable during the Japan crisis— see here)

  • More and more debt has been used to finance non-productive sectors (e.g. “ghost cities”) as opposed to infrastructure

Zombies, ghosts … soon trolls and death eaters? Clearly not sustainable. Having said so, our lead economist in Beijing is arguing that the country’s Minsky moment is still far (far) away.

Here is what needs to be known to put many of the alarming headlines in perspective

  • China’s aggregate leverage at the national level is similar to that of the U.S. and below that of the Eurozone (300%+) and Japan (400%+) whilst it has a faster economic growth and thus deleveraging potential

  • The majority of debt has been used to finance infrastructure investment with positive returns over the long term

  • High domestic savings (45% savings rate) associated with a sizable current account surplus have allowed more than 90% of the debt stock to be financed domestically

  • Banks are largely owned by the government who also controls the central bank, the lender of last resort

  • The capital account is relatively closed, which limits capital outflows

China’s leverage is thus essentially a China issue—a closed circuit. If anyone can pull the plug on the credit cycle, it is China itself. Needless to say, the longer the credit cycle lasts, the more resources will be misallocated since activities which should be eradicated are instead subsidized. This has direct implications for the country’s economic growth potential.

What is the way out? In its usual function of a bien-pensant, the IMF suggests in a report published earlier this week that China embark on a comprehensive corporate restructuring strategy designed to improve the performance of viable companies and facilitate the orderly exit of the non-performing ones. This would allow for a more optimal allocation of resources, higher earnings, higher returns on investment, a higher economic growth potential and thus some faster deleveraging.

China has actually declared that it intends to adopt such a strategy, although its implementation is riddled with issues of social (employment) and microeconomic (selection of winners vs. losers) nature. In any event, the debt-financed acquisition of foreign targets by Chinese companies at sky-high premia may not last beyond the next few quarters since its consistency with a restructuring strategy is doubtful.

At the higher level and based on the above considerations, China should be able to avoid a Minsky moment. Instead, it will most likely grow at a rate which—like many things these days—will stay lower for longer.

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