China is the central factor in global debt risk. Image: iStock

The globe is currently saddled with an unprecedented amount of debt, and this is expected to rise further as fiscal spending to boost economies takes place. Central to this trend – and related risks – is the global economic engine, China.

Currently, debt-ridden governments remain calm as they consider debt to be manageable and some experts believe that controlability is more important than debt size. Yet, history provides plenty of warnings.

The 1997 Asian financial crisis was a result of excessive corporate debt, and a decade later, the 2008 global financial crisis was triggered by excessive mortgage loans though mortgage-backed derivatives in the US.

Hur Kyung-wook, a former South Korean ambassador to the Organization of Economic Cooperation and Development and an ex-vice finance minister warned Asia Times in an interview that another debt crisis is looming – with China the potential trigger.

Debt without deleverage

“Global debt is about 3.2 times [global] GDP, according to the International Institute of Finance,” Hur, who currently serves as an adviser to Bae, Kim & Lee, a major Seoul law firm and who, in addition to his government service, also worked at the International Monetary Fund and the World Bank, noted.

But the bigger problem, he averred, is that the world has largely ignored urgent debt obligations without deleveraging, following the GFC of 2008.

While households and businesses formerly went bankrupt in crises, eventually leading to deleveraging, during the 2008 crisis, debts were transferred to central banks and governments through quantitative easing and through the rescue of troubled corporates or banks.

“In the past, this was never the case in the course of crisis resolution,” he said. “Debts and the debt ratios to GDP have increased since the crisis; in other words, liquidity supply has increased.”

Monetary easing brought forth low-interest rates and low investment returns, creating the “yield hungry” phenomenon of investing in high-yield assets. ”Through this investment behavior, debt was transferred from developed countries to developing countries,” he said.

According to a January report from the Institute of International Finance, global debt stood at $244 trillion as of the third quarter of 2018 – up about $27 trillion since 2016.

The debt-to-GDP ratio edged down to 318 percent from a record high of 320 percent in the third quarter of 2016 as economic growth has reduced debt-to-GDP ratios somewhat, but it remains stratospheric.

Out of the $244 trillion, government debt was tallied at $65.2 trillion, non-financial corporate debt stood at $72.9 trillion dollars and financial sector debt was $60 trillion dollars, while households owe $46.1 trillion dollars.

The IIF noted that government debt and non-financial corporate debt, in particular, have continued to grow, accounting for 75% of global debt growth since 2008.

”Previously, supplying liquidity would create inflation,” Hur said. “Raising interest rates to counter inflation would make it difficult for debt-ridden corporates and banks to repay debts, resulting in them selling assets and deleveraging.”

That is not the case today.

“Inflation has not occurred despite the quantitative easing of the past decade as the pace of liquidity circulation has slowed,” Hur said. “The economy is also beginning to slow.”

Europe was originally scheduled to normalize its monetary policy following the US, but Washington stopped that process due to its own slowing economy. So, rather than monetary tightening, Europe may lower interest rates yet further, and Japan is in a similar situation. Moreover, China had been tightening its monetary policy until two years ago, “but it has turned to an eased stand due to the U.S.-China trade war,” Hur said.

And there is no end in sight, raising risk still further. “We can’t afford to see this situation go on forever,” Hur said. “No one knows when the debt crisis will happen but chances are getting higher and higher.”

Hur expects a bust to occur as a result of a major interest rate hike or economic hard landing.

Populism also bodes ill for the global economy, he said. “In many countries…populist governments have come into play, further raising the debt issue,” he said, adding that the G20, created post-2008, is failing to address the problem.

The China risk

He predicted that China, which has seen a surge in corporate debt, is likely to trigger the next crisis.

”China is the country where corporate debt has increased the most since the global financial crisis,“ he said. ”The ratio of corporate debt to GDP is higher in China than that of in the US when the Lehman Brothers crisis erupted or in Japan when the real estate bubble burst.”

Currently, Chinese companies’ debt is almost 160% of GDP, according to the IIF – way higher than the 132% percent in Japan in 1989 when the Japanese bubble burst. Household debt also rose to 51% of GDP. Local government debt has continued to grow thanks to stimulus measures, but the ratio of government debt to GDP is at 48.5 percent, a relatively stable level.

Hur agrees in part with the view that the Chinese government can control corporate debt – but that does not mean that the problem can be resolved.

“There is a possibility of a hard landing even if it may be able to avoid a crash landing that could lead to the collapse of the financial system,“ he said. “It’s hard to tell what would happen if China’s debt problem erupts, but it could be contained internally as China controls foreign exchange transactions and holds more than $3 trillion in foreign exchange reserves.”

What is helping the country avoid a full-blown crisis is that the portion of foreign debt to the country’s total debt is relatively small.

“China’s financial system is dominated by the government,” he said. “The government has transferred the debt of the four major banks to asset management companies established to handle major banks’ debt, to allow these banks to continue lending. China will try to gradually reduce its liability for a long time in this way.”

However, it seems difficult to avoid negative impact. There could be a sharp downturn in the economy with credit slashed and real state prices plunged, he suggested. And even absent a collapse of the Chinese financial system, “a sharp downturn in the Chinese economy could send shockwaves through the global economy,” he said.

The Korea Center for International Finance also revealed concerns about China’s growing corporate debt in a report published in January, saying that “corporate debt has been a factor which exacerbates the economic slump by causing bank insolvency and reduced private investment.“

According to the report, China’s corporate debt amounted to $20.3 trillion as of the second quarter of last year – up 4.7 times from $4.5 trillion in 2008. Its ratio to GDP also jumped to 155.1%.

Coupled with a contraction of the property market, the impact of an economic downturn could be amplified: About 60% of collateral in corporate bond issuances is real estate, and real estate companies issue 35.6% of corporate bonds.

The report noted: “If the Chinese government’s stimulus policy fails to operate efficiently amid worsening internal and external environments, the delayed corporate restructuring and industrial innovation could amplify China’s economic instability and put a heavy burden on the global economy.“

Don’t panic 

However, there are also positive voices.

“China’s bankruptcy rate has gone up, but it’s small in size,” said an expert who closely monitors global bond markets. “So far only small businesses have faced defaults. Big companies which can exert a huge impact on the Chinese economy have been saved. If the Chinese government, which controls financial institutions, responds to the debt problem like this, I think the chances of a crisis occurring are not great.”

Other key economies are relatively stable. According to the IIF, US government debt amounted to 108.7 percent of GDP as of the third quarter of last year and Japan’s government debt has recently exceeded 250 percent of GDP.

But Japan’s government debt problem is less severe as it has little foreign debt and low interest rates. This means it is manageable – as long as Japanese government debt growth does not exceed GDP growth. And although Washington is massively indebted, with the dollar the key currency, there is no risk of sovereign default.

Some experts see the possibility of a foreign debt crisis rising among emerging economies. When the Fed signaled a normalization of monetary policy, financial markets in some emerging economies  panicked.

However, Hur sees little problem there. “There has already been considerable differentiation between emerging economies,” he said. “Some emerging countries vulnerable to risk have been through crises already and with differentiation underway, emerging market crises, if they happen, will be very regional.”

Leave a comment