As mentioned in another article, there are three main types of debt we need to keep in mind when analyzing a country: household debt (mortgages, personal loans, etc.), corporate debt (corporate loans/bonds) and government debt. Ask the average observer what type of debt he/she is least familiar with and, of course, corporate debt will most likely be the choice in question.
Time and time again, the dangers associated with public debt are analyzed, with Japan oftentimes being presented as the #1 culprit in light of its public debt to GDP ratio which is well north of 200%. In contrast, we are dealing with roughly 4 times less as far as China is concerned. The same way, debates surrounding reckless consumerism abound, with US consumer-related stereotypes usually in the spotlight and, once again… China ends up ignored in light of the fact that from a household debt to GDP ratio perspective, it is only at a roughly 61.5% level compared to the United States.
Whenever topics surrounding corporate debt arise, however, many observers flip the channel due to the fact that at the end of the day, household debt (a type of debt the average person most likely has) and public debt (the type of debt the public “knows” will affect it) feel let’s say closer to home, whereas corporate debt seems too abstract of a concept.
And it’s precisely the corporate debt dimension where China can end up becoming a textbook “how NOT to” example, in light of the fact that we are looking at a corporate debt level of over $20 trillion. As a bit of a comparison, Germany’s corporate debt to GDP level is roughly 3 time lower than that of China, that of the United States as well as the United Kingdom roughly two times lower and even Japan looks better, with a 1.6 times lower one.
Can corporate debt issues bring down the financial system of a country?
If the country in question represents a major economy such as China, can corporate debt issues generate contagion and risk bringing about a major threat to the worldwide financial system?
At the end of the day, we need to understand that the financial system of a country is ridiculously vulnerable at this point in time. As such, even a more serious sneeze when it comes to household, public and/or corporate debt can be enough to trigger a chain reaction that makes the financial system essentially grind to a halt. If there is anything the Great Recession has taught us, it’s that we shouldn’t over-estimate the resilience of a nation’s financial system… or the worldwide one, for that matter.
What tends to be the proverbial trigger?
More likely than not, an uncontrollable default chain reaction.
How do things stand when it comes to corporate defaults in China at this point in time?
For 2019 (let’s not even talk about the 2020 situation just yet, that is a topic for another article), the default rate was north of 4% and how this value can be interpreted depends on… well, whom you ask:
- A pessimist will quickly point out that it’s the trend we can consider dangerous, in light of the fact that back in 2017 (two short years ago), the default rate was south of 1%
- An optimist, however, will state that the 4% zone does not pose problems and that the corporate debt dimension can be contained, with the higher figure being to a large degree explained by the fact that the Chinese authorities are encouraging the deleveraging process (lowering debt levels) and letting market forces act in a controlled manner
While it is true that China has been letting defaults to occur in a somewhat “natural” manner and will probably not intervene if the issue is not something with systemic potential, fewer words are more dangerous than “contained” in a financial setting. Let us not forget that prior to the Great Recession unfolding, experts (including the Federal Reserve Chairman at that point in time, Ben Bernanke) were going on and on about how “suprime” (risky loans) was contained, yet it was precisely the subprime dimension which generated the Mortgage-Backed Security tsunami which became (in)famous and led to the Great Recession.
Does this mean it is time to panic?
No, it is never time to panic, primarily because that is something those caught off-guard tend to do and if you as an investor and/or trader are caught off-guard, it may very well be too late to act in an optimal manner. Instead, we simply recommend paying attention whenever “elephant in the room” situations occur (with 2020’s economic crisis being a prime example in that respect), even if it seems that the authorities are more than eager to ignore them.
To remain in Great Recession analogy territory, those who paid attention to the subprime dimension had ample time to prepare so as to land on their feet or even more so, generate generation-defining profits which even inspired a wide range of movies (Margin Call, The Big Short, etc.).
This is the message we keep trying to get across here at ChinaFund.com: China is most definitely not a perfect jurisdiction, an El Dorado for investors or anything along those lines. It is a country like many others, with pros as well as vulnerabilities and there is absolutely nothing wrong with that. It just so happens that as far as the topic of today’s article is concerned, the corporate debt dimension most definitely represents such a vulnerability for China, to a considerably greater degree than for other countries.
As long as you understand the nature of the game you are playing and the “turf” in terms of jurisdictions, it’s up to you how you treat vulnerabilities. Those who are less risk-tolerant will simply put together hedging strategies that enable them to land on their feet under a wide range of circumstances, whereas more aggressive risk-takers will try to find ways to profit from them. Whether it comes to the former, the latter or anything in-between, the ChinaFund.com is more than happy to put its brainpower at your disposal.