Global Debt and the End of Days

• 15-Oct-21
• admin

A 2019 Hollywood movie, End of Days, envisaged that this “End” happens in a dystopian environment, caused largely by climate change.

 

Before that occurs, we may see an end of civilization as we know it because of global debt crushing economies and causing a breakdown of society.

 

Will that happen?   

 

Can it become violent?

 

The global economy at the start of the 2020s is mired in debt.   The three most prosperous economies in the world, the US, China and Japan, have so much debt that there is no possibility that they can actually redeem that debt in our lifetime.   Probably not even in two.

 

Are they in financial trouble?   Let’s look at the data and see if we can make sense of it.

 

There is some hyperbole regarding the rapid growth of debt in the Chinese economy.   A number of media articles have been published in recent days citing data that China has borrowed its way into a dead end, and that the end of days will soon come for its super-charged growth.  

 

This narrative has been used by a number of Western media sources to again bash China; saying that the rise of Chinese debt has been so fast that it is now at the level of the US national debt, which has always been thought of by journalists as too much.    And the financial media postulates that when this debt is due, the economy will not be able to handle it, leading to a fatal crash of the Chinese economy.  Evergrande is the start of it.   Blah, blah, blah…

 

Really?  

 

I mean, it’s getting like this blog is now written to counter idiotic Western journalists all trying to jump on the bandwagon of being China experts predicting an imminent China economic collapse.   It reminds me of a book written by a certain Gordon Chang, predicting The Coming Collapse of China, published in 2001.   Of course, that never happened.   It has been 20 damned years since that dire prediction.    We all held our collective breath for a few years, assuming that books written by so-called experts are usually not completely full of shit.   Well, now we know better.   

 

Similarly, nothing in the current narrative that China is having an uncontrollable debt problem can be further from the truth.      

 

These journalists who write these tales of doom and gloom are not experts, especially when their ignorance of Chinese history, culture and social norms seeps through their foolish, reckless narratives.   And in this latest case, on the chest-thumping about the dire Chinese debt growth, they did not even bother to study the charts and diagrams they print in their own newspapers or websites to first check if their stories made any sense.

 

So much for objectivity in negative China news these days…

 

Anyway, let’s do the hard work for them.  

 

 

If we just look at the chart above, created by a renowned financial newspaper using Bank of International Settlements data, it tells us that the Debt to GDP ratio of several major economies is rising over time.   So what?   

 

The story is in the meeting of the deep purple (China) and the dark blue (US) lines.   The focus of all the fuss is how the deep purple line (China debt to GDP growth) has caught up with the dark blue line (US debt to GDP).   Yes, that does say that China overall debt is now about the same level of the US debt based on nominal GDP.   This is what the hollering is all about in recent financial press.   

 

Well, as usual, there is more than meets the eye.

 

First of all, there are two problems with this simplistic analysis.    GDP measured in nominal terms is not accurate, and if we take the correct cross-country measure of GDP in purchasing power parity terms (PPP), the debt to GDP in China is nowhere close to the US level.   (Technical note:  if China’s GDP PPP is larger than the US’ GDP PPP, then the Debt to GDP ratio in the case of China will be smaller than the US’ ratio, since GDP is the denominator).   This is the first misinterpretation of the statistics.  It blows the journalists’ story away.

 

But let’s grant these noisy guys their simplistic choice of methodology – that we accept the use of nominal GDP in the denomination of the Debt to GDP ratio.   Does this raise the spectre that China is borrowing itself to ruin, just as the US has already done?   Is this narrative then correct?

 

If we look at another chart, which is the same one but simply updated to 2021 (the first chart ends in 2015), the analysis has to be modified.   Here is such a chart:

The two charts up to 2015 is identical.   It does show that the China’s Debt to GDP ratio has caught up with the US’.    But let’s see what happened in the second chart after the two lines (brown for China, black for the US) touched…well, the two tracked each other for more than six years, without a distinguishable difference - meaning that the rapid growth of China’s debt in the years from 2010 to 2015 did not continue.   At worst, it can be said that both countries (and Europe) all had the same Debt to GDP ratio, stabilised at around 250 percent of Nominal GDP in the most recent few years.   It is by no means “faster” growth in China than in the US since 2015.   

 

And on our further argument that if the denominator is switched to PPP GDP, then China’s debt ratio through the five years from 2015 to 2021 is definitely below the US and Europe, and does not give support to the contention that China’s debt growth is at a frantic pace, as portrayed by financial journalists using the earlier data.  

 

I would even suspect that the journalists in the renowned newspaper chose to stop the chart at 2015, just to make the story better to tell, even if it is in fact BS.

 

One should also note that the Japanese Debt to GDP ratio has been higher than all other countries tracked in the two charts above.   Financial analysts and yen FX, stock or bond traders have actually known this for more than 20 years.   Didn’t need journalists to tell us.

 

Why was there never a cry of wolf, when excessive debt seems to have happened in Japan from a long time ago?   More importantly, if the debt to GDP ratio is such a great indicator of unsustainable debt leading to economic collapse, why hasn’t Japan broken a long time ago?

 

The reason is that each country has its own particular circumstances for its debt situation, and it is not useful to compare debt levels and draw up horror stories like some financial journalists have done.  

 

The Yen has always had such low interest rates that many traders around the world are keen to do a “carry trade” based on the Yen.   The carry trade involves borrowing in Yen to invest in other currencies.   This is basically an interest rate bet, when one borrows at a low interest rate in one currency, and lends at a higher interest rate in the other currency.  As long as the exchange rates do not change too much, the trade would be profitable.   With people happy to borrow Yen, usually without much mishap, there is probably a greater comfort level with high levels of Japanese debt.

 

The other key thing about Japanese debt is that it is largely owned by Japanese domestic institutions such as insurance companies, trusts and pension and retail housewives (often described as Mrs Watanabe like they are called Aunt Agatha in the UK) who put family savings into bonds and stocks.   This is a very stable source of funds, and there is unlikely to be many of these investors suddenly withdrawing the funds, causing defaults.    Neither do Japanese institutions move money in and out of assets much.   If most of the investors do not cause ripples in the pond, why would there be waves?

 

Also, given that the Japanese savings rate is very high, the high debt to GDP ratio is not really a problem. 

 

The average savings rate against total income in Japan is around 35%.  During a single year 2020, households built up 36 trillion yen in savings or nearly 7 percent of GDP.    Given that Japan’s national debt is mostly to its own people, and that population can save at 7 percent of GDP, their debt level is not considered a serious problem in global markets.   

 

Most importantly, it is a stale story, unlike the new juggernaut on the block, China, where most journalists would like be the first to find a tale of boom and bust.    

 

Besides, that borrowing in Japan is spent mostly domestically, and since Japan does not really spend much on wasteful expenditures like defence, cleverly letting the US carry that immense burden, all its government spending is on building up infrastructure in its own country, or on social spending on its own people.  

 

The structure of the debt in the US and in China are also quite different.  This can be seen in the diagram below:

 

 

The above chart shows the difference between US and China debt.   Most of the latter’s debt has been incurred by the corporate sector, with households and government taking much smaller percentages of GDP as debt.     US government debt to GDP by comparison, is about twice as large.  And American household debt is almost as large as government debt.  The following critical points about the two countries debt, in terms of their serviceability, can be made:
 

1. Chinese household debt is mostly backed by mortgages, while American household debt is in mortgages, student loans and credit cards. Which can we say is more stable?  

 

1. Chinese government debt is small, and is in fact the lowest among all the countries shown in the chart.   As we know, most of it goes to infrastructure, which pays dividends long into the future.   Government debt in China is definitely sustainable.

 

 

1. Chinese corporate debt is high, and indeed has been soaring.  This is largely due to the tremendous growth in the economy, and debt is a function of the opportunities embedded in that growth.  Borrowing by business would have paid off.
2. American debt by comparison has not been deployed to productive uses that would help to reduce the debt burden in future years.   In that respect, we all know that the proceeds of a significant amount of US debt is spent on military budgets of an army deployed in 800 bases around the world, and on actual wars - 15 years in Iraq and 20 in Afghanistan.   That is a “great sucking sound” for money going down the tubes.   None of that comes back. 

 

All said, the American and Chinese situations are quite different.  For China, because government debt is relatively small, it is the government that is seeking to redress and reduce the fast growth of credit incurred by the private sector in the economy.    The Chinese government is actually restraining debt growth, doing the responsible thing, and making the economy more resilient. 

 

This is entirely different in America, where it is the government, and a weak household sector, that is doing all the heavy duty borrowing.  The American government is leading the charge on getting more indebted, instead of trying to rein in it.    

 

If one of the two is not sustainable, then it is more likely to happen on the American side.

 

Given the above observations once the debt structure is broken down for analysis,  it becomes obvious that even if the debt levels relative to GDP of the US and China are indeed accepted to be about the same in quantitative terms, one has to ask the crucial question on the quality of the spending.   Debt needs to be serviced and if there is no capability to service debt, then default is inevitable. 

 

My humble conclusion is that the hyperbole about Chinese debt, recently spooked by Evergrande, is nothing to worry about.   The analysis above supports the view that this problem of excessive corporate debt will pass.   The Chinese economy and the national debt is healthy.   Especially because the Chinese savings rate, at 45% of GDP, is even higher than Japan’s.   The availability of financial resources to dampen any individual borrowers’ default is immense. 

 

For the US, even if much of the high debt levels has been incurred by unproductive expenditures, they have not reached a level when we worry that the End of Days is here.   Japan has been there before, and it is still a very rich country.   So even if America came close to minting a trillion dollar coin (this has fortunately been avoided), its problems are more political than economic.

 

That however does not eliminate the problem of long term inflation in the global economy.  Instead of an End of Days scenario, we may instead have lingering death.   It’s called inflation.

 

Photo by <a href="https://freeimages.com/photographer/ctechs-29846">Jeff  Prieb</a> from <a href="https://freeimages.com">FreeImages</a>

 

Wai Cheong

Investment Committee

The writer has been in financial services for more than forty years. He graduated with First Class Honours in Economics and Statistics, winning a prize in 1976 for being top student for the whole university in his year. He also holds an MBA with Honors from the University of Chicago. He is a Chartered Financial Analyst.