Trade war with US could be the tipping point for China’s $14 trillion debt-ridden economy

  • Nearly 20 percent of China's exports go to the U.S.
  • If a trade war ensues with the U.S., China's GDP growth would drop 0.5 percent and could continue to fall as things heat up, the IMF warns.
  • China's debt-to-GDP has ballooned to more than 300 percent from 160 percent a decade ago.
  • Chinese officials now warn of a financial-sector debt bubble that's waiting to burst.

While some of the rhetoric around trade tariffs on China has died down over the last couple of weeks, the prospect of a trade war has not. On April 18, China imposed preliminary antidumping tariffs of 178.6 percent on sorghum, a crop used to make alcohol and biofuels, while President Donald Trump's threat to impose tariffs on $150 billion worth of goods on everything from solar panels to aircraft to cars remains on the table.

If an actual U.S. trade war ensues, then China's economic growth prospects could be negatively impacted in a significant way. While the country's economy has shifted inward over the last few years, relying on its own citizens to fuel growth, it still exports billions of dollars in goods and services every year. Last year it sold $506 billion in exports to the United States — nearly 20 percent of its exports go to America — while the United States sold just $130 billion to the Chinese.

In January the International Monetary Fund said China's economic growth would top 6.6 percent in 2018, but it could now drop by as much as 0.5 percent if these tariffs are imposed — and it could slow even further if a global trade war truly heats up. China's economy can likely weather a small decline in growth, in part because of its increased reliance on domestic spending, but this isn't the only potentially GDP-destroying situation it's dealing with.

Over the last few years, China's debt-to-GDP has ballooned to more than 300 percent from 160 percent a decade ago, causing many people, including Chinese officials, to warn of a financial-sector debt bubble that's waiting to burst.

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"If you look at classic indicators like debt-to-GDP or corporate-debt-to-GDP and how that's risen over time, then there are flashing yellow lights," said David Dollar, a senior fellow at the Brookings Institute's John L. Thornton China Center.

How did it get so bad? After the recession, the country spent trillions on infrastructure projects, with many banks, including unregulated or "shadow" banks, loaning money to companies that have been unable to pay back their debts. According to a Chinese news outlet, Lai Xiaoming, chairman of China Huarong Asset Management, one of the country's biggest asset management firms, said that total volume of nonperforming loans could hit a record $476 billion by 2020.

Non-performing loans are loans made by banks or shadow banks to companies or citizens that haven't been paid back, or where interest payments haven't been made. The risk is that these loans never get paid back and banks start losing money in droves, said Peter Pauly, an economics professor at Toronto's Rotman School of Management.

Many of these loans were made to finance infrastructure projects, which did help the economy. China's GDP growth hovered between 9.5 percent and 10.5 percent between 2008 and 2011, but it's become clear that the spending was done at a cost.

"Leaps and bounds the infrastructure in China has improved, but the other side is that investment was done through a very underdeveloped monetary system," said Pauly "It was a wild west kind of expansion and the overleveraging has been a result of the lack of control over that process."

Bigger than the financial crisis

It's nonperforming loan problem may be even worse than people think, said Pauly. China's communist party is dealing with an underdeveloped banking sector with little regulation, at least compared to America's. Dealing with this kind of system and the bad loans that have been made because of it, present a formidable challenge for the government, he said.

The biggest issue? Its $20 trillion shadow banking industry, which is nearly impossible to figure out. In fact, the value of nonperforming loans could get even worse, if only people knew just what was happening inside of this murky shadow banking sector.

"No one knows who owes what to whom or how much," said Pauly. "Only when it starts to go bankrupt will things start falling apart."

The shadow banking system may be the most worrisome financial issue in decades, added Pauly, even more problematic than the sub-prime mortgage meltdown that fueled America's financial crisis.

Mark Ralston | AFP | Getty Images

Many of these nonbank institutions have financed risky infrastructure operations, like copper and coal mines or other poorly constructed buildings, by using a variety of unusual financial instruments, said Louis Lau, director of Brandes Investment Partners' investments group.

Traditional banks have also sold their bad loans to these nonbank companies, which have then packaged them up in products for sale to consumers and, also, back to the banks.

Having trillions in unregulated wealth management products floating around is "huge risk" for the economy, said Lau. If these loans don't get paid back then banks could start going bust, while local governments, some of which have been a beneficiary of these loans, and other companies could find themselves underwater, too.

Ultimately, China went too far in propping up its economy after the recession.

"The global crisis was a big shock to them and they responded with a lot of infrastructure investment," said Dollar. "They overdid it and got into investments with low returns."

If China's banks start failing, then that will certainly cause markets to panic. With most of these debts being held by Chinese entities, it's unlikely we'll see a banking crisis in the same way we could have seen if Greece or Spain went belly up, said Lau — many foreign banks hold European bonds — but we've seen markets panic on far less worrisome Chinese news in the past.

China's making reforms

Despite its massive debt-to-GDP numbers, the chance of China going belly up is minuscule, said Lau. The government is taking measures to reduce the number of bad loans. In November it set up the financial stability and development committee, a regulatory body to create and enforce tougher banking rules and coordinate financial reform.

One of the things the government has told banks to do is to stop offering guaranteed investments — many banks made guarantees, which has forced the government to bail out the holders of these products when guarantees haven't been met — and it's also trying to bring off balance debts back onto balance sheets, said Lau.

As well, the four biggest banks in China, which are considered high-quality operations, account for 70 percent of the banking system, said Lau. These four companies haven't been engaged in the same kind of financial tomfoolery that others have partaken in.

"More than half the banking system is not participating in these wealth management products," said Lau. "They're largely safe."

China's also has other ways it can prop up its banking system if need be. If can pay the interest on nonperforming loans, or create "bad banks," says Pauly, that hold bad loans. At least then everyone knows that the bad loans are contained at one institution.

"They have so many domestic levers they can pull," said Pauly. "They can prop these banks up as long as is necessary."

Trade war pressures

Even if China can prevent a crisis from happening, being over leveraged is still bad for growth. Lau pointed out that, historically, countries with high debt loads eventually see their growth rates fall. Couple that with a trade war and China's GDP could drop faster than many people think.

As it stands now, U.S. tariffs on China won't have as devastating impact on the Red Giant's economy that some in government may want it to. The country is much less export dependent than it used to be — "the U.S. is making a miscalculation about that," said Dollar — and it may be able to get around tariffs by exporting its goods to other countries, added Pauly.

However, if America decides to put tariffs on all it imports from China, about $500 billion worth of goods, then it's economy could slow in a more meaningful way. Couple that with its financial issues and it's not impossible for growth to slow more dramatically.

"If growth slowed to 2 percent, then that would be a crisis," said Dollar.

That kind of growth would cause problems within the country, especially if job losses mount or growth remains slow for the long term, but Dollar said a steep decline economic expansion may be just what the country needs.

"There are various reforms they need to do, so if lagging on the reforms and getting into a trade war with the U.S. results in a sharp slowdown in growth, then maybe they respond by opening up the economy more and dealing with their financial risks and creating a more market oriented economy," he said. "They might be better off having the crisis because that will help focus the political minds on what needs to be done."

In any case, a dramatic slowdown in China would cause investors to worry and that's never a good thing. And even if the country can save itself in the end, China's problems shouldn't be taken lightly.

"These financial issues in China are serious," said Dollar. "Throw in the trade conflict and that definitely complicates things for the country."

— By Bryan Borzykowski, special to CNBC.com

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