“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” These scenarios, developed by the economist Ludwig Mises, seem dire. Will they apply to China?
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It is well-known that China has a high ratio of debt to gross domestic product (GDP). If the sum of all loans in an economy is less than the sum of its annual value-creation, the economy is creating net wealth. If there is more debt than value-creation, no wealth is being created; the growth is only in the numbers.
However, the amount of debt alone might be just one indicator of the magnitude of the problem that a debt-fueled economy faces. The other dimension is how quickly debt accumulates.
In 1998, the debt-to-GDP ratio in the United States was about 120 percent. When the bubble burst in 2008, the ratio was at 170 percent. So in 10 years, the ratio of debt to the country’s total value creation rose by about 42 percent. It took the U.S. nearly 10 years to recover. In 2016, the U.S.’s debt-to-GDP ratio was about 105 percent.
Japan’s debt-to-GDP was about 140 percent in 1980 and grew to 230 percent by 1990. This was a 64-percent rise in 10 years. (It remained high until 1998.) Thailand had a debt-to-GDP ratio of “only” 80 percent in 1988, but when the Asian crisis hit in 1998, the ratio was more than 170 percent – a rise of more than 110 percent. In Spain, its debt-to-GDP ratio was 90 percent in 2000; by 2010, when the housing sector crashed, it was about 210 percent – an increase of more than 130 percent. These three countries have yet to fully recover.
Chinese authorities are trying to deflate the bubble, or at least stop the surge of credit
And China? Around 2007, the Middle Kingdom had a debt-to-GDP ratio of about 110 percent; today it is more than 220 percent – a doubling in 10 years.
Of course, in China, most debt is in the hands of the state, state institutions or state-controlled enterprises. The government, which still centrally plans the economy to a large extent, might be able to steer its debt and its economy. This is the best-case scenario.
But there is also a worst-case scenario: if the credit bubble bursts. Then, the state sector would bring down the whole economy. This would have a huge impact on the region, foreign bondholders and investors, among others.
However, there is a third scenario that is more likely than the worst case but less optimistic than the best. Chinese authorities are trying to deflate the bubble, or at least stop the surge of credit. This might prevent a crisis, but will have a negative impact on all the businesses that create only debt-driven value.
In the long-run, if Beijing succeeds in preventing a credit crisis, it will be for the greater good of the country and the region. For as Mises stated in 1947: “Credit expansion can bring about a temporary boom. But such a fictitious prosperity must end in a general depression of trade, a slump.”