How the Chinese Economy may be miss-interpreting Leverage for Genius

After the financial crisis in 2007, Steve Eisman, one of the few who predicted the housing crash well enough to take a massive short position against it, said the wall street bankers “mistook leverage for genius”; a memorable and profound quote, especially for the time.

When he said this, he was of course referring to the increasing loans banks would take out on their assets, so if everything went bust at once, the whole market would collapse as everyone would go bankrupt. I think we’re seeing a similar scenario play out in China, and although I strongly stand against the notion that China will blow up the same way the US did, I do believe china is sitting in a debt bubble that will lead to stagnated growth, one that could both lead to inflation of the Chinese yuan and selloffs of their assets, impacting the US heavily if they sell of significant amounts of US debt or dollars.

For me this journey started a long time ago, but only got serious recently in Walmart after hearing about trade talks. I’ve always paid attention to where things are made, but after looking into US trade deals I’ve learned that the US has a free trade deal (FTD) of sorts with most every democracy in South and Central America, as well as many other poorer countries in Africa and Asia; but you don’t see products from these places anymore. I used to buy shirts from El Salvador and steel wheels from Mexico, but now days we don’t. Now days everything is made in china with the possible exception of stamped plastic, which tends to be made in the US as it requires no labor.

I think there are a lot of reasons for this. China tends to have overproduction issues, leading to artificially cheap products steaming from artificially cheap resources. They’ve built up many of the supply chains, and the country invests heavily in itself. But all of these things come from one source: debt. China is a massive debt holder, especially considering they have over 5 trillion more in debt than the US despite having half the economy size; that’s a worse debt to GDP ratio than Japan. Once they stop growing at ~6+% annually the world isn’t going to let them continue to take out as much debt, putting an end to many of their self investment programs and cheap money. This could be devastating to the export portion of their economy, and although I don’t think the government will let factories close easily it will make them much less competitive on the world market.

There is one thing I want to make absolutely clear: I don’t think this will spell out destruction for their economy. They are fast approaching a strong consumer economy, and have many jobs and sectors (such as intranet companies like Tencent and tech sectors like electronics manufacturing) that won’t leave without an armageddon scenario like Venezuela. Additionally as the rest of their economy becomes more modern it’ll become easier and more efficient to tax citizens, generating new avenues of revenue for the country.

But I do think the country will have a debt crisis, and I do think many foreign creditors and investors will absorb much of the costs associated with this. Chinas current assets (such as factories, and other industry) will be protected by the government, but more private investments inside the country will likely find it hard to compete with their private-public Chinese counterparts, and I believe they’ll find themselves in a harder position exporting to the rest of the world as well when this happens. I would suspect we’ll see something like this happen either once China reaches growth akin to other developed countries (around 2%) or if it hits any sudden and sustained drops in growth (although it is possible we’ll see the government try to cover up this stalled growth as well, as we’ve seen them, for lack of a better word, forge growth rates before).