Thursday, June 19, 2014

The Economic Efficiency Of Credit Can Collapse

It might soon become apparent the economic efficiency of credit is beginning to collapse and the additional money poured into the system coupled with lower rates can no longer drive the economy forward. When this happens many of our economic policy options will vanish. This interesting concept may be soon put to the test as new problems emerge in China where we are seeing the extra GDP growth generated by each infusion of money drop from 0.85 to 0.15 over the last four years. This might be taken as a sign of exhaustion. The collapse of credit can pose major problems such as what we saw when many sellers were forced to demand payment up front before shipping goods in 2008.

Wei Yao from Societe Generale says the debt service ratio of Chinese companies has reached 30% of GDP the typical threshold for financial crises. This means many companies will not be able to pay interest or repay principal. She warned that the country could be on the verge of a "Minsky Moment" when the debt pyramid collapses under its own weight. "The debt snowball is getting bigger and bigger, without contributing to real activity," she said. The total credit in China's financial system is estimated to be as high as  221% of GDP and has jumped almost eightfold over the last decade. This means companies will have to pay out $1 trillion in interest payments alone this year. Chinese corporate debt burdens are much higher than those of other economies.

Currently, much of the liquidity that exist in China's economy is being used to repay debt and not to finance output. The fact that new investment in factories has slowed drastically is probably a good thing because China is awash in overcapacity. New factories sit idle because of weak demand. This also raises concerns over an exodus of hot money once the US Federal Reserve starts tightening. China might see a large-scale capital outflow if and when there is an exit from quantitative easing and the dollar strengthens. This maybe already starting with recent withdrawals from Chinese equity funds the highest since early 2008 and withdrawals from Hong Kong funds the highest in a decade.

Fortunately, China's Central government carries little debt on its books. This gives the central government the option to step in if a worse case scenario develops and bail companies out or put them on life support as Japan did so many years ago.  Many people think if things get worse China might have to take action to help real estate companies or even worse recapitalize the banking system, but this will not fix all the problems. I'm forced to reflect on how debt is directly affected by interest rates. In Europe, the ECB has stepped in to halt the economic collapse of Spain, Italy and several other countries that were on the brink of collapse by instituting false super low-interest rates. 

What you pay in interest on debt does matter except in the current manipulated land of  Modern Monetary Theory. Often referred to as MMT its believers see it as a way to remove much of the risk ahead and guarantee the economy will always be able to muddle forward by altering and changing the procedures and consequences of using government-issued tokens and our current units of fiat money.  Newly acquired tools like derivatives and currency swaps allow us to print and manipulate away problems. Unfortunately, the part where you collect a debt that you are owed can be similar to a mirage that keeps moving away each time you approach it. Do not forget the small print that governs most contracts often tells us rules can be changed causing many people and companies to become instantly insolvent.

Why do you want to loan money if most likely you will never be repaid or repaid with something that is totally worthless? We are abusing the large amount of wiggle room in our economic system and our ability to put off the day of reckoning only proving that we will until we can't! Modern society has become very good at kicking the can down the road and delaying the consequences of bad policy.  This means that at some point the return on loaning money is simply not worth the risk! When this happens the only safe place to store wealth will be in "tangible assets" and the only lenders will be those who print the money that nobody wants.

Footnote; This post dovetails with many of my recent writings, for more I might suggest reading the article below. Other related articles may be found in my blog archive, thanks for reading, your comments are encouraged.


  1. This is also proved by economic models. Growth rates are high when the base is low but it slows down as the economy gets bigger.

    GDP growth at the root is two factors, more labor hours and productivity increase. When China opened up itself, labor participation grew in the export market and those earnings were invested in domestic infra which added productivity gains and contributed to domestic consumption turbocharging the growth. After two decades of this phenomenon, productivity gain is hard to come by. No amount of further investments can give the productivity boost it saw before. Credit not only loses efficiency at this phase, it becomes non-performing asset and can undo some of the growth.

  2. nice article thanks for sharing for more about china economic you can read Chinese economy