China’s mix of politics and economics makes it an interesting study for economists, investors, and regulators. The controlling Communist Party of China has a stronger grip on its economy than other governments which proves problematic for an atmosphere in which the party advocates such high growth targets for business expansion. The only way in which China can reach such high growth targets is by taking out a lot of debt, comparatively, and this is what is making the foundation of their economy unstable.

Past countries have had problems when taking out a big line of credit that continued to expand for nearly a decade and grew to a ratio of above 1.5 to their GDP. The longer the problem is put off the bigger an economic crisis hits and for longer. The 1997 Asian Financial Crisis is the key example of showing how financial contagion could plague today’s even more well connected economics. Southeastern Asian countries weren’t the only ones affected as Italy and Spain still show the effects today. The tipping point is when debt to GDP levels rise to 200%, which China has surpassed especially with growing household debt on top of the huge mound of corporate debt.

Chinese investors are thrilled at the results of their banks, but at the dismay of international investors that fear their increasing leverage is due for an impending problem with loans increasing by 10.2% when real growth is not even close. Couple that with decreasing interest rates which could be a protectionist move to protect asset values, but this only a bandage on the problem. If deflation were to ever hit China, the consequences could be severe, especially on a commerce economy that is reliant on their currency never appreciating too much in value. Reserve requirements have been cut and construction growth is mostly reliant on fiscal spending on the government’s behalf and is not truly organic. Additionally, shadow banking activity has increased within Shanghai and banking regulators have ordered checks of lenders in effort to have better oversight. China could take a lesson from Stein’s law.

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