If China Really Deleverages, Expect Recession

In the modern monetary/financial system, money is created by banks. (When the banks run into trouble, the central bank monetizes the debt and the banks start lending again. The central bank is the caboose, not the engine.) Most of this creation took place off-balance sheet and eventually led to the 2008 financial crisis. As Jeffrey Snider of Alhambra has shown, the U.S. financial system "peaked" in 2008 because the large financial institutions began shrinking their balance sheets. The European banks topped out in 2011. If China deleverages, it's banks will top out in 2017 or 2018. On-balance sheet lending will rise, but if China deleverages, it will not offset the slowdown in off-balance sheet lending.

Credit demand spends the same way as real demand. Goldman Sachs estimates total debt increased 13.5 percent in 2017 to 317 percent of GDP.

GDP was 82.7 trillion yuan and credit increased 31.1 trillion yuan, a total of 113.9 trillion nominal demand, up 9.0 percent from 2016.
If total credit growth slows to around 10 percent in 2018, and assume nominal GDP is goalseeked and rises 9 percent, then total nominal demand would be 116.4 trillion, or 2.2 percent growth. Even with a generous forecast for nominal GDP growth, the slowdown in total nominal demand is huge. If you take a more bearish view of GDP, then outright recession is likely even if it is masked by most official stats.

Bloomberg: While Washington Spends, China Moves to Cut Its $30 Trillion Debt Load
Few think China faces a near-term crisis from its debt. The economy is growing at a robust 6.9 percent, and domestic deposits of $27 trillion almost equal outstanding debt. If China were to simply continue the rapid credit growth and wasteful investment of the past, a sharp and wrenching downturn would likely result. At some point the country’s ability to roll over existing debt and fund new projects will wane.
China always faces a near-term crisis from its debt. That's why it must get a handle on debt levels. The longer it takes, the larger the inevitable crisis.
Make no mistake: China’s great deleveraging will be a multiyear undertaking, and the country is just getting started. There also may well be instances of backsliding. Yet China’s debt dynamics are now so pressing that there’s probably no turning back.
China needs a burst of real GDP growth to offset the decline in credit growth required to get credit-fueled, centrally-planned growth below the growth rate of the whole economy. It needs the private economy to overtake the state economy. It's like a race between the tortoise and the hare, the tortoise is private GDP and the hare is credit + state GDP. If China can't wait for the tortoise to catch up, it has to slow the hare. It can slow the hare anytime because it controls the hare, but slowing the hare will also slow the tortoise. Finding the right number isn't easy and the Chinese government can't control global growth or U.S. trade policy.

If China could have grown without credit-fueled centrally-planned growth, it would have done so. Had China implemented reforms in 2008 or 2011 or 2014 it would have needed a smaller bump in real GDP to offset the credit slowdown. A bullish view of a credit slowdown requires China to do what it failed to do for 10 years and do it far better than it would have back when the problem was smaller.

A less optimistic view is China avoids a major crisis, but that depends on how you view the financial markets of early 2016. If you think that wasn't a serious decline that required incredible credit intervention from China, then there's no reason to be worried if global growth slows. Or perhaps U.S. growth picks up thanks to fiscal stimulus, Europe improves too, and the dip in Chinese demand is partially offset by global demand.

And then there's the bearish scenarios that range from a repeat of late 2015 and early 2016, all the way to full blown financial crisis in China, global recession, EM carnage and the DXY at its final nosebleed high.

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