Getting a Handle on China's Credit Bubble

Here is a chart of the change in GDP in the United States divided by the change in Total Credit Market Debt Outstanding (TCMDO). What this chart shows is the falling utility of debt. The first dollar of credit can generate a high return for a business, but each additional dollar of debt has less impact. This is a basic concept in economic (and in life). One can die from drinking too much water, and eventually, adding too much debt leads to losses, such that cutting debt actually increases growth.

The key number for a credit bubble is when the increase in GDP from debt does not exceed interest costs. If interest rates are 5% and an increase in debt only generates a 4% increase in output, then it is a losing proposition and default is coming.

In 2008, nominal Chinese GDP stood at $4.5 trillion. At the end of 2013, Chinese GDP stood at $9.3 trillion. That is a net increase of $4.8 trillion (this is nominal GDP, which in some years grew at more than 20%).

Credit In China Has Grown From $9 Trillion To $24 Trillion Since 2008. A net increase of $15 trillion.

Over the past five years then, the increase in GDP divided by the increase in debt equals 0.32. That's around the rate at which the U.S. was seeing in the 1980s and 1990s. In China, the cost of capital is higher and the economy is (supposed to be) growing at a faster rate. So if China is effectively adding debt at the same rate as the 1990s economy in the U.S., that jives with investors such as Marc Faber who say China's GDP growth is closer to 4%.

China crisis may be unavoidable
I, however, question the idea China can grow its way out of this problem.

That's because, first of all, the debt issuers are not the primary beneficiaries of gross domestic product growth. The primary beneficiary of GDP growth is the central government, which gains in the form of tax revenues. Debt issuers, on the other hand, are mostly local and their primary revenue source is land sales.

There is no direct, mechanical or automatic link between economic growth and local authorities' debt service capacities, as we have witnessed since 2008 as total social financing, a broad measure of credit, has exploded.

The argument that China can grow out of its credit bubble is valid if and only if GDP growth increases the debt service capacity of the debtors. As GDP is only a measure of economic activity, not efficiency or profitability, GDP growth alone does not guarantee a proportional increase in the revenue of local authorities that could be used to pay down the debt issued via financing vehicles.
Start to question the quality of Chinese GDP growth and the picture is worse.

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