Why Do Credit Bubbles Pop?

One of the great advantages of the Austrian school is that it does not use mathematics to try and divine the future. Rather, the key is to understand human behavior. In the case of credit bubbles, there is no magic percentage of GDP at which debt levels become unsustainable. Smaller nations and industries are obviously at the mercy of larger players. With no larger player, such as with a Chinese or American credit bubble, the bubble ends because people think it will end. As the bubble inflates, more and more people believe it will end. Then it is only a matter of the trigger event that crystallizes this belief. Thought becomes action and the bubble has burst.

Theoretically, a bubble can go on forever as long as people think it will keep going on, but this requires that people do not change their behavior or expectations. This never happens because people do respond to prices and incentives. Lower interest rates cause people to borrow more, which leads to higher growth and eventually higher prices (monetary inflation filtering through the economy). There is no equilibrium in the economy, ever. Real interest rates are either rising or falling and for a trend to continue, it requires that the trend never stop or that people perfectly change their behavior in the right proportions in order to keep the economy on an even keel. This doesn't happen because most people do not have great insight and instead use the wisdom of crowds: they follow the herd.

Will the failed trust product market by ICBC (see: Pop Goes the Trust; Chinese Investors Learn the Hard Way That Credit Does Not Equal Gold) be enough to change perceptions and change the direction of the market? It's hard to predict. I consider one thing: is the credit bubble large enough to justify a change in behavior? And if behavior changes, will the effects be great?

Credit bubbles require increasingly large amounts of new credit in order to keep the growth rate steady. It can be a constant rate of growth, but this results in increasingly large nominal numbers and since the credit is growing faster than GDP, it leads to an ever widening gap/rising debt-to-GDP ratio. Investors and business discount this amount of new credit and become accustomed to easy money. They do not worry about having cash because they feel secure with a line of credit. After 2008 hit, many people lost their credit access. Corporations saw the commercial paper market screech to a halt and some faced bankruptcy, with concern that even blue chips like General Electric (GE) could go bust due to an inability to roll over short-term debt. The result was that in the ensuing years, corporations issued hundreds of billions in new long-term bonds and stuck the cash on their balance sheets. Businesses also make long-term plans assuming the good times will continue. As the credit bubble grows, a smaller and smaller change in credit growth leading to a small change in GDP growth can have a major impact on an individual firm or sector in the economy, which sets off a chain reaction.

Who knows if China is at the point of a major trend change, but China definitely is at risk of a major trend change and has been for years. Here is Andy Xie on the topic: When the Giants Unwind
China's tightening is really about limiting local government borrowing. They are not interest rate sensitive. The current rise in interest rate is unlikely to dent their appetite. Indeed, China's local governments went to the shadow banking system for money at high interest rates in 2013, as banks have become wary of too much exposure to them. Local governments depend on the perception that provinces and, ultimately, the central government will bail them out, if they can't repay their loans. This is the reason that the shadow banking system is focusing on them. Private companies have been borrowing at low interest rates offshore and lending to them at high interest rate, either directly or through trust companies. Unless the bailout responsibility is clarified, China's credit bubble would continue.

If the central government spells out its position of no bailouts clearly and convincingly, the reaction in the credit market will likely be massive. The shadow banking system, for example, wouldn't roll over their loans. Unless the banks step in – probably forced by the government – a financial crisis is possible. If the banks do step in, it is actually a bailout by the central government, as it will be forced to bail them out if they go down. When moral hazard is the main reason for a credit boom, cooling it slowly is very difficult.

I have always argued that a hard landing would be a good thing for China. It flushes out all the financial excesses quickly and allows the economy to have a fresh start and soon. China's labor shortage ensures that such a landing wouldn't lead to social instability. Declining inflation would improve people's living standards. Hence, it's all good looking from the people's perspective. The banks and local governments wouldn't look at it that way. They all hope to stretch out the time horizon for paying off the legacy costs from the bubble. Or better that the people in charge now could walk away before the problems are exposed. Hence, the system's bias is to drag it out. But, a bubble grows larger if it doesn't burst. One cannot hold a bubble stable; it either shrinks or expands.

China is showing some resolve in reigning in the credit bubble. A credible anti-corruption campaign and rising interest rate are the visible signs. The tightening path is anything but assured. The system's bias for stable appearance may cause the policy to change direction.
I agree with his outlook. A hard landing is very possible, but it would also be very bullish for China. The anti-corruption campaign is extremely strict. Government officials, and almost anyone spending government money (which includes a lot of sectors such as education), cannot spend more than 20 yuan per person on meals, and they must eat buffet style. I know that some many departments have cancelled overseas trips and domestic travel that used to be a work/pleasure combination. The screws are tightening and the people fear Xi Jinping means business. That is a good thing, but it also means that if the credit market tightening is for real, China is going to be at risk of a very hard landing for the duration.

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