Chinese Assets Are Inflated By Debt

Bloomberg: China Debt Crisis? The Other Side of the Ledger Suggests Not

Well to answer that question, the best place to start is with the oft-overlooked other side of the ledger: assets. On that score, China's balance sheet looks a lot rosier, suggesting prospects for ``financial Armageddon'' may be overblown, according to Bloomberg Intelligence economists Tom Orlik and Fielding Chen.

As of 2013, total assets were about 900% of gross domestic product, versus debt of about 220 percent.

I lend you $100, you have $100 and I have a debt asset worth $100. In this simplistic model, if you take on a massive amount of debt and cannot repay it, then my assets are worth far less than the nominal paper value.

The real economy works a little differently. When the bank loans you $100, they create a $100 out of thin air. They don't give you someone else's $100, they credit you $100. The supply of money and credit increases as you spend the $100 conjured out of the bank's balance sheet, and the bank's $100 asset also circulates in the financial market. If you can't repay the loan and go bust, the bank's $100 asset may be valued as low as $0 if there is nothing to recover. In this case the asset side would drop by $100 and the liabilities would drop by $100 as well.

There is no national balance sheet. Someone in the Chinese economy might own a lot of assets free and clear, but some other people owe a lot of debt and some people own a lot of debt (banks). If there are defaults, the assets transfer to the bank and the losses come out of capital. Capital impaired banks cannot lend as much money, which reduces money supply growth, leading to more asset price declines, defaults, impaired balanced sheets, and less lending. It goes until there are no losses left to take, which is why central banks always step in and buy debt assets off the bank's balance sheets for cash. It shores up the banking system and the lending cycle begins anew.

A recent example of a country will a good balance sheet: the USA. The subprime housing crisis in the U.S. happened despite all the homes in America being worth far more than total outstanding mortgage debt. It only takes a small number of defaults to trigger a significant crisis in a leveraged financial system. If leverage is 10:1, it only takes losses of 10% to wipe out the lender. People often make this mistake with China:

But the strong position does reduce the chances of a debt crisis in China, the analysts wrote. Case in point: with household debt about 17 percent of real estate assets, house prices would have to fall by 80 percent to push households underwater.

No. The debt isn't evenly spread across the economy. Some people are leveraged way up in real estate because they've borrowed the down payment from somewhere, possibly from private lenders. Home owners aren't the key risk anyway, it's the developers and trust loans tied to those developers that represent a greater risk in that sector. The individual balance sheets are key and if enough are upside down, it is a big problem, no matter how many assets other people in the economy have on their balance sheet.