China: TANSTAAFL

Forbes: China 'Debt Bomb' More Like A Bottle Rocket

McKinsey Global Institute says that from 2007 to 2014, China’s total debt, including debt of the financial sector, nearly quadrupled, to $28.2 trillion, or from 158% of GDP to 282%.

The most positive take is that China is a demographically aging country running up a pile of debt similar to the developed world, a uniquely large and centrally controlled economy that can deal with the debt. A crisis is avoided, but the debt load and demographic changes leads to sub-5% annualized GDP growth. Negative spin: every emerging market that saw a similar debt increase suffered a crisis.

Another new report, by economists at the Hong Kong Monetary Authority says the rise in indebtedness has been partly related to a big stimulus package launched in 2008 to 2009 following the U.S. mortgage debt bomb, a debt bomb that was noted by a few, like Addison Wiggins, and denied by most. There is no equal in China to the housing and derivatives bubble collapse in the U.S.. There’s no AIG with mortgage backed securities it bought on triple leverage. There’s no subprime mortgages in the market. Unlike the deficit-financed stimulus packages in the West, led by the Toxic Assets Relief Program in ’08, China’s trillion dollar stimulus package was funded mainly by state bank credit at the muni level. This was done largely to keep China’s full-employment policy in full effect.

There are a lot of subprime players such as the credit guarantee companies who guaranteed bank loans. (See: Credit Guarantee Firms Go Down Like Dominoes) They used AIG's business model and they are backing a lot of loans on the banks' balance sheets. Banks gave out loans to very bad credit risks because credit guarantee firms put their stamp of approval on them, but in many cases, the credit guarantee firm is one default away from bankruptcy.

The buildup state company debt has been policy driven leverage designed to keep Chinese people employed. These companies would have borrowed less if they were basing their decisions on the market. But, again, China is not a market economy. At least not fully. So the same rules of thought do not apply when analyzing this country from afar.

In a market economy, we could assume the debt was at least used efficiently, even if it was for unproductive consumption. Even though the market is being distorted, it is still responding to market signals. When interest rates are too low, capital flows away from the most efficient uses to the less efficient uses. Entrepreneurs and consumers behave as if there is more capital in the economy than exists. Projects that are unprofitable at higher rates of interest are started and consumers spend more than they otherwise would. When rates are normalized, the boom turns to bust and the economy finds it has even less capital because of the malinvestment during the boom years.

China is in worse shape than a market economy because the capital that it did allocate from 2009 to 2014 was often directed by local government officials who had the political power to directly intervene in the real estate market. The level of intervention taking place in sectors such as steel is off the charts in comparison to developed markets and China's only avoiding the full brunt because it is passing the cost onto foreign steelmakers, a solution that is about to end shortly.

Another article hits the same theme in Forbes: 10 Reasons Why China's High Debt Level May Not Be As Bad As It Appears

There are costs to central planning and intervention in the market economy. Those distortions grow over time and there is always a bill to be paid. All the Chinese government can do, to the extent it can control the economy, is decide where the pain is felt. Keeping in mind that as reform opens the capital account and the domestic economy, the government has less control than before. The question you need to answer isn't will China have a crisis, it is who gets the bill? Where does the distortion flow to next?