The Daily Reckoning Presents

China’s Debt Bomb!
By Chris Mayer

China seems to do everything big. It has the largest power station in the world and the longest high-speed railway line. It also has the world’s largest public bathroom (which can hold over 1,000 people) and the world’s largest pyramid.

So when it came to attempts to pull its floundering economy out of the muck, the Chinese went big. Economist Ben Simpfendorfer writes that China’s total credit stimulus in the four years since 2009 was worth $11 trillion. “Enough to buy the world’s entire oil supply for three consecutive years,” Simpfendorfer writes, “even with oil prices at above $100 a barrel.”

What follows here is another look at China’s debt-fueled spending binge and how it impacts your investments. As China is also the world’s largest buyer of most commodities — at the margin — what happens in China will have a lot to say about the prices of oil, copper, iron ore, etc.

To summarize: It will not end well. But first, a little review on this issue of China’s debt.

Most people tend to think of China as not having a debt problem. This view is at odds with the facts. I cite again my friend, Ben Simpfendorfer, who edits the excellent China Insider. He has spent 15 years living and investing in Asia and the Middle East. (He is fluent in both Mandarin and Arabic!)

Ben has done the work of figuring out what China’s debt levels are. He has spent the time digging through China’s own government documents. (As the great Izzy Stone once observed, “All governments lie, but they seldom lie to themselves.”) I won’t go through the numbers. I’ll just give you the conclusion:

“China’s economy became increasingly reliant on debt during the latter half of the 2000s. Moreover, the rise in non-loan debt financing has also grown, making it difficult to pinpoint just how large an increase in debt is needed to sustain growth...”

What he refers to here is the murky lending done outside the banking system, which makes it harder to track. The end result, though, is a high level of aggregate debt: “China’s aggregate debt levels are still significantly higher than many in the region, albeit still lower than those in Korea and the US. However, the level of business debt is high relative to any country, especially the US.”

Why does this matter?

Because if China’s growth is mostly due to the temporary effects of stimulus spending, then it casts doubt on the ability of the economy to keep up that pace. It means future growth is much slower than in the past.

And it means trouble for commodities.

A recent Wall Street Journal story addressed this issue. In a piece entitled, “Stock Markets Throw a Party; Commodities Aren’t Invited,” Liam Denning zeroes in on some flaws of China’s model.

One of the more interesting insights is from Chris Watling of Longview Economics. Denning, summarizing Watling, writes that, “of the major emerging economies, China’s has been the most reliant on credit growth while also suffering the lowest return on capital.” Watling’s insight adds another crucial dimension to the story. Not only is China spending lots of money, it is getting less and less of a return on the money it spends.

But Denning’s main point is to link China to commodities. He has an interesting chart, which he uses to show the divergence between two great asset classes — stocks and commodities. Take a look. The MSCI World Index represents stocks. The CRB Index represents commodities: