2014-10-26

China's Rollover

The journey from luxury to thrift will test Beijing’s mettle
This year China is set to pay an interest bill of about $1.7tn, an amount not far short of India’s entire GDP last year ($1.87tn) but larger than the economies of South Korea, Mexico and Indonesia.

...Companies are affected because, according to estimates by Standard Chartered bank, some 32 per cent of new credit these days is used simply to pay off the interest on existing debts. Consumers are compromised because overall debt service charges now equate to about $1,290 out of the annual per capita GDP of $6,800. Local governments – still the main agents of investment – are also feeling the pinch, as was clear from a finance ministry proposal this week to allow them to issue new bonds purely to fund the repayment of their maturing liabilities.

The Wikipedia entry on Hyman Minsky will suffice:
Minsky argued that a key mechanism that pushes an economy towards a crisis is the accumulation of debt by the non-government sector. He identified three types of borrowers that contribute to the accumulation of insolvent debt: hedge borrowers, speculative borrowers, and Ponzi borrowers.

The "hedge borrower" can make debt payments (covering interest and principal) from current cash flows from investments. For the "speculative borrower", the cash flow from investments can service the debt, i.e., cover the interest due, but the borrower must regularly roll over, or re-borrow, the principal. The "Ponzi borrower" (named for Charles Ponzi, see also Ponzi scheme) borrows based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with the cash flow from investments; only the appreciating asset value can keep the Ponzi borrower afloat.

If the use of Ponzi finance is general enough in the financial system, then the inevitable disillusionment of the Ponzi borrower can cause the system to seize up: when the bubble pops, i.e., when the asset prices stop increasing, the speculative borrower can no longer refinance (roll over) the principal even if able to cover interest payments. As with a line of dominoes, collapse of the speculative borrowers can then bring down even hedge borrowers, who are unable to find loans despite the apparent soundness of the underlying investments.

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