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Balance sheets matter. This is the biggest lesson of the financial crises that have rolled across the world economy. Changes in balance sheets shape the performance of economies, as credit moves in self-fulfilling cycles of optimism and pessimism. The world economy has become credit addicted. China could well be the next victim.
If we think about balance sheets in the world economy of today, four questions arise. First, what determines vulnerability? Second, where are vulnerabilities now appearing? Third, how are countries coping with the legacy of old debt crises? Finally, can the world economy cope with the new vulnerabilities?
Start with the sources of vulnerability. In economies with liberalized financial sectors, the driver towards disaster is far more often private than public imprudence. Rising property prices and expanded mortgage lending drive many credit booms. A deterioration in the public sector's balance sheets usually then follows crises. Failure to recognize this link between private excess and public borrowing is wilful blindness.
In an update of work on debt and deleveraging, McKinsey notes that between 2000 and 2007, household debt rose as a proportion of income by one-third or more in the US, the UK, Spain, Ireland and Portugal. All of these countries subsequently experienced financial crises. Indeed, huge increases in private sector credit preceded many other crises: Chile in 1982 was an important example of this connection.
Ruchir Sharma of Morgan Stanley argues that the 30 most explosive credit booms all led to a slowdown, often a crisis. A rapid change in the ratio of credit to gross domestic product is more important than its level. That is partly because some societies are able to manage more debt than others; it is partly because a sudden burst in lending is likely to be associated with a sudden collapse in lending standards.
Thus, in seeking new vulnerabilities, we need to look for economies that have had sharp rises in private debt. China leads the pack, with a rise of 70 percentage points in the ratio of corporate and household debt to GDP between 2007 and 2014 (see chart). If we add financial sector debt, the rise in gross private indebtedness is 111 percentage points. With government debt included, it is 124 percentage points.
China's huge credit boom has several disquieting features. Much of the rise in debt is concentrated in the property sector; "shadow banking" — that is lending outside the balance sheets of the formal financial institutions — accounts for 30 per cent of outstanding debt, according to McKinsey; much of the borrowing has been put on off-balance-sheet vehicles of local governments; and, above all, the surge in debt was not linked to a matching rise in trend growth, but rather to the opposite.
This does not mean China is likely to experience an unmanageable financial crisis. On the contrary, the Chinese government has all the tools it needs to contain a crisis. It does mean, however, that an engine of growth in demand is about to be switched off. As the economy slows, many investment plans will have to be reconsidered. That may start in the property sector. But it will not end there. In an economy in which investment is close to 50 per cent of GDP, the downturn in demand (and so output) might be far more severe than expected.
Now consider the state of countries that suffered huge crises since 2007. McKinsey notes that none has deleveraged overall. Yet non-financial private sectors have deleveraged in some cases, notably the US, UK and Spain. The financial sector has also deleveraged substantially in the US, though not in Spain or the UK. In these cases, however, the rise in government debt has been bigger than the decline in private gross debt. Indeed, gross debt has risen relative to GDP in all the high-income economies examined by McKinsey, with the exception of Israel. In many high-income economies, even private indebtedness has continued to rise: Canada and France are two noteworthy examples of this experience.
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The substitution of public borrowing for private borrowing in the aftermath of a crisis makes sense. In most cases, the public sector — a close-to-eternal borrower — is far more creditworthy than those who had borrowed excessively. Nevertheless, some limit certainly exists to the rise in public debt.
Moreover, in the past, countries that expanded public sector debt in the immediate aftermath of a crisis were subsequently able to generate debt-free growth via exports. This is not a generalizable strategy when much of the world is struggling with excessive debt. Some mixture of financial repression, monetization, inflation and debt restructuring now seems certain in many countries. The faster economies grow, the less likely such outcomes are. Given its demographics and high debt, Japan's task is particularly challenging.
Yet this is for the longer term. The more immediate question is what happens if the world has at last run out of big economies able or willing to run large asset-price fueled credit booms. A plausible consequence might be that global economic growth will be substantially slower than many now hope. Another, discussed last week, is that economies that are emerging from the aftermath of credit bubbles will be enticed into new ones: the US and UK come to mind. This would surely be a dismal outcome.
The world desperately needs new ways to manage its economy, ones that support demand without creating unmanageable rises in indebtedness. If the affliction is now affecting China, then it will have befallen all the large economies. With debt continuing to rise, it is likely to spread further. In the absence of radical reforms, the world economy depends on generating fragile balance sheets. Better alternatives are imaginable. But they are not being chosen. In their absence, expect crises.