When you are concerned about a borrower’s credibility, you should not just look at outstanding obligations under current conditions. You should also worry about outstanding obligations in case of a likely adverse shock.
When we think of Spanish government debt, for example, we don’t just think of the current debt load of 69 per cent of GDP (or wherever it has climbed to since the end of last year), or even of the contingent liabilities from provincial debt and non-performing loans. We must also be concerned about the self-reinforcing relationship between the debt and the currency.
If Spain were to leave the euro, in other words, because much of its debt is external debt denominated in euros, any devaluation of the new currency (let’s call it the peseta) would cause a corresponding increase in the debt burden. The peseta could easily lose 50 per cent of its value, for example, in which case the external debt burden would double its share of GDP.
There is a self-reinforcing relationship between the two. Since investors are aware of the risk, the worse the debt-enhancing impact of a devaluation, the more likely the devaluation is to occur, and the higher the external debt, the greater the actual devaluation will turn out to be.
We saw this most spectacularly in Argentina, whose debt-to-GDP ratio, if I remember correctly, was 'only' around 53 per cent in the period just before the December 2001 corralito and debt default, which was itself followed immediately by the January 2002 devaluation. An earlier, equally spectacular case was that of South Korea in 1997. Its relatively small external debt burden before November 1997 became unbearable just one month later after the forced devaluation of the Korean won.
What does this have to do with China? Perhaps quite a lot, given the many pro-cyclical structures embedded in the country’s economy and balance sheet. If we assume that China will have no problem sailing through its economic rebalancing, the European crisis, and everything else, then clearly we don’t need to worry about anything. But if China’s rebalancing is accompanied by a sharp slowdown in economic growth, or if it occurs during a worsening of the European crisis – both very likely scenarios – then we need to think about what the debt burden will be under those conditions.
So, for example, will commodity prices drop? I think they will, perhaps by as much as 50 per cent over the next three years, and to the extent that there is still a lot of outstanding debt in China collateralised by copper and other metals (and there is), our debt count should include estimates for uncollateralised debt in the event of a sharp fall in metal prices. Will slower growth increase bankruptcies, or put further pressure on the loan guarantee companies? They almost certainly will, so we will need again to increase our estimates for non-performing loans.
Will capital outflows increase if growth slows sharply? Probably, and of course this puts additional pressure on liquidity and the banking system, and with refinancing becoming harder, otherwise-solvent borrowers will become insolvent. Will rebalancing require higher real interest rates, a currency revaluation, or higher wages? Since rebalancing cannot occur without an increase in the household income share of GDP, and since these are the biggest implicit 'taxes' on household income, there must be a net increase in the combination of these three variables, in which case the impact on net indebtedness can be quite significant depending on which of these variables move most. Since I think rising real interest rates are a key component of rebalancing, clearly I would want to estimate the debt impact of a rise in real rates.
There is more to say elsewhere on where I think we should be concerned about inverted balance sheet structures in China, but my main point here is that very often – in fact in the majority of cases – debt crises catch us by surprise because there is a sudden and unexpected surge in debt caused by factors we hadn’t thought about. It is the sudden and unexpected explosion of contingent liabilities that generally precedes debt crises, and not the actual debt burden a year or two before the crisis, that ends up triggering the crisis.
Just remember the finger wagging and the self-satisfied lectures on banking and debt given by senior Spanish government officials and bankers to US and European bankers as late as 2009. No one thought Spain had a problem until debt suddenly emerged from every nook and cranny as a response to the adverse shock Spain was undergoing. Some analysts will complain that it is very difficult to figure out all the contingencies in any country, so acknowledging the possibility adds nothing to the quality of our analysis. But they are dead wrong. An experienced balance sheet analysts can easily tell when overall a country’s balance sheet is more inverted or less inverted, and in the former case he must always assume that the potential for a debt crisis is much greater than the raw debt numbers suggest.
By the way I am not suggesting by any means that Beijing’s current debt level is unsustainable, but I do think it is hard to argue that it has not been rising at an unsustainable pace in recent years. What is more, in every single case in history that I can remember, during a great liquidity-driven bubble, debt structures became increasingly inverted and risky, especially in poor, developing countries, and more especially in countries whose rapid growth is driven by rapid investment growth funded by a financially repressed banking system. The reason should be obvious – when the cost of capital is artificially repressed, economic entities tend to overuse capital as an input. Perhaps that has not happened in China in the past decade, but if it hasn’t, China would represent a truly unique case in history.
We need to be worried about debt in Europe and the US of course, but we need also to be worried about debt in China. The deleveraging process in any country always results in much slower growth than during the period in which debt was rising quickly, and what matters is overall deleveraging, not just government debt. At some point we will see deleveraging in China, and this must affect growth. Misallocated investment funded by debt means that losses have occurred and one way or another they will eventually be recognised. The recognition of the losses can be postponed for a time, by the simple expedient of not recognising non-performing loans, but at some point, and usually at the worst possible time, they will be recognised.