With China’s debt swelling from $9 trillion to $23 trillion during the past five years, Rothschild Wealth Management feels the credit bubble will burst at some point.

Rothschild in its recent research paper points out such an elevated level of debt is unsustainable and leaves China’s financial system vulnerable to a credit crunch.

China’s galloping debt level

To arrest the falling export demand in the wake of the 2007-08 financial crisis, the Chinese government came out with a $600 billion stimulus package and monetary expansion. Though these efforts revived China’s economic growth, they had the effect of its credit growing at an annual rate of staggering 20%.

According to People’s Bank of China, the ratio of total debt to GDP has ballooned by over 50% during the past five years and currently stands at a staggering 200%. Rothschild’s research report points out that Japan, too, had crossed the threshold level only a few years before its economy crashed in 1989.

More importantly, China’s economy still requires such enhanced level of credit to buttress its growth, roll over existing loans and service the interest payment on existing debt.

Rothschild’s report cautions such an alarming level can’t continue forever. Besides, credit continues to expand in China as Chinese banks’ lent $115 billion in August, while its shadow banking system lent over $130 billion.

The following graph highlights significant increase in China’s total social financing, thanks to its expanding shadow banking sector:

China's debts

Recently, analysts estimated China’s total debt, including household, government and corporate debt could be as high as 200%.

China’s growing shadow banking system

According to Rothschild’s research report, China’s bad loans increased not only with major banks but also in the shadow banking system, threatening its overall financial stability. It is estimated to have increased from $3 trillion in 2010 to $6 trillion by the end of 2012. Shadow banking is an undefined area of the market, which covers all credit outside of the regulatory system. The government’s efforts to curb credit growth in banks have led to a huge increase in shadow banking activities.

Rothschild’s report points out China’s shadow banking system is highly interconnected, opaque, and beginning to show signs of strain.

The following graph highlights the increasing role played by the shadow banking system:

Shadow banking

Though over-extension of credit on such an elevated scale doesn’t make a crisis inevitable, the Rothschild report points out both the International Monetary Fund and the Bank for International Settlements have concluded that the risk of such a crisis is not negligible if the pace of growth is allowed to persist for a longer period of time.

Rothschild’s research report concludes the credit bubble is unlikely to burst imminently. However, the risks in China’s banking system are significant, and the report cautions investors to protect portfolios by reducing direct and indirect exposure to China.

China’s Credit Bubble.pdf by ValueWalk.com