Crescat Capital Q2 letter to investors has in-depth analysis on the Chinese credit bubble below
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History has proven that credit bubbles always burst. China by far is the biggest credit bubble in the world today. We layout the proof herein. There are many indicators signaling that the bursting of the China credit bubble is imminent, which we also enumerate. The bursting of the China credit bubble poses tremendous risk of global contagion because it coincides with record valuations for equities, real estate, and risky credit around the world.
The Bank for International Settlements (BIS) has identified an important warning signal to identify credit bubbles that are poised to trigger a banking crisis across different countries: Unsustainable credit growth relative to gross domestic product (GDP) in the household and (non-financial) corporate sector. Three large (G-20) countries are flashing warning signals today for impending banking crises based on such imbalances: China, Canada, and Australia.
The three credit bubbles shown in the chart above are connected. Canada and Australia export raw materials to China and have been part of China’s excessive housing and infrastructure expansion over the last two decades. In turn, these countries have been significant recipients of capital inflows from Chinese real estate speculators that have contributed to Canadian and Australian housing bubbles. In all three countries, domestic credit-to-GDP expansion financed by banks has created asset bubbles in self-reinforcing but unsustainable fashion.
Post the 2008 global financial crisis, the world’s central bankers have kept interest rates low and delivered just the right amount of quantitative easing in aggregate to levitate global debt, equity, and real estate valuations to the highest they have ever been relative to income. Across all sectors of the world economy: household, corporate, government, and financial, the world’s aggregate debt relative to its collective GDP (gross world product) is the highest it has ever been. Central banks have pumped up the valuation of equities too. The S&P 500 has a cyclically adjusted P/E of almost 30 versus a median of 16, exceeded only in 1929 and the 2000 tech bubble.
The US markets are also in a valuation bubble because US-owned financial assets have never been more richly valued relative to income as we show below. The picture is equally frothy if we include real estate, also at record valuations to income. China’s capital outflow spillover from its credit bubble has driven up real estate valuations around the world.
The unique aspect of the current global credit bubble is that China has emerged at its epicenter. Since 2008, China has created the world’s largest M2 money supply, the world’s largest and most grossly mismarked banking assets, the largest global trade with the rest of the world, the second-largest GDP, and the world’s largest credit-to-GDP imbalances.
Based on our studies of past financial crises, forecasting credit bubbles that are ready to burst with a high probability requires a combination of two key macro indicators that have been proven out across different countries and across time:
1. A high absolute level of debt to GDP relative to history
2. A high recent debt-to-GDP growth relative to long-term trend, what the BIS refers to as the “credit-to-GDP gap”. The credit-to-GDP gap flashes a warning signal of a potential banking crisis when credit growth rises more than 10% above its long-term trend.
The chart below shows thirteen countries with significant credit imbalances based on one or both measures. Note that at least ten of the countries have significant trade and capital flow links with China.
The first panel in the chart above shows seven countries including China that have historically high household and corporate debt compared to GDP, our first indicator. The second panel shows the top-ten countries today with the highest credit-to-GDP gaps according the BIS, our second indicator. Note that six of the credit-to-GDP gap countries are in Asia. They include China and five related “Asian tiger” economies. Hong Kong has both the highest outright debt-to-GDP and the highest credit-to-GDP gap of all countries tracked by the BIS today. Hong Kong is not even technically its own country. It is part of China under a “one country, two systems” concept. One is Chile, the world’s largest copper producer and copper exporter to China. Four countries overlap on both indicators: Hong Kong, China, Canada, and Singapore.
What the chart above emphasizes is that not only is China in a credit bubble that is poised to burst, it is linked to many other countries through trade and capital flows that also have large credit imbalances making the China bubble even more significant. The nexus of China with these other credit bubbles is just one of the reasons that we believe China is ground zero for a pending financial crisis that will have global repercussions.
Using the “credit-to-GDP gap” to flag likely credit busts is based on the work of economist Hyman Minsky, an academic whose career focused on studying the causes of financial crises. Minsky’s models were posthumously credited with predicting the global financial crisis and adopted by the BIS. Minsky’s “financial-instability hypothesis” essentially postulates that long stretches of prosperity sow the seeds of the next financial crisis. A long stretch of prosperity was certainly the case with China over the last 25 years as shown in the chart below. China’s share of global GDP grew from less than 2% in the early 1990s to almost 15% today. China even accelerated its growth rate in the wake of the global financial crisis in 2008. Since then, China has been the largest GDP growth economy in the world accounting for 54% of global GDP growth.
The problem is that long stretches of prosperity tend to be delivered with increasingly speculative leverage and unproductive investment activity. The China growth story is not likely a miracle of communist government central planning; it’s a massive credit bubble, almost certainly the largest ever. China’s impressive growth has come overwhelmingly and almost exclusively from unsustainable credit expansion combined with extensive, largely unprofitable domestic infrastructure expansion. In the last two decades, China has seen the largest construction boom in any country ever. The construction boom can be seen in the chart below by looking at the portion of China’s GDP that has gone into fixed asset investment which has grown almost every year since 2000 from 23% of GDP to 87% of GDP in 2016
We believe this has been a centrally planned misallocation of capital into white elephant, unproductive fixed-asset infrastructure projects that on balance will likely not ever generate sufficient return on investment to justify their cost. The penalty will come from China’s future economic growth.
A recent study by