2008: Financial Armageddon
For years, America’s financial sector was thriving. Low interest rates and stable growth had many Americans feeling optimistic about the state of the economy. Before 2008, deregulation allowed for investment banks to make risky investments with stockholder money and practice irresponsible lending, while rating agencies failed to accurately report mortgage riskiness and the SEC neglected Wall Street. These factors—among many—contributed to the ticking time bomb that would eventually plunge the global economy into crisis. In America the effects were devastating, with 8.8 million Americans left unemployed and 6 million foreclosed homes. Overall the direct cost of bank losses made up 8% of the country’s GDP.
The impact was global and nearly brought down the world’s financial system, leaving 30 million people unemployed and costing the world economy over $2.8 trillion. Although the housing bubble collapse of the US was the result of a unique combination of irresponsible actions from big banks, government, rating agencies and home buyers, the world is still vulnerable to another crisis—this time, from a different economic heavyweight.
China’s Debt Causes Concern
Despite its 45% drop in exports following the recession, China’s economy suffered minor damage from the 2008 crisis, and was able to fully rebound to its long term GDP level by 2010, cutting unemployment to 4%. This was largely due to the government’s $586 billion stimulus package that injected money into different industries and projects, providing work for 95% of those who had lost jobs. Eight years later, speculators are suggesting that China is risking a future crisis due to its unstable credit growth, which has contributed to a housing market bubble of its own. China’s housing market boom alludes to unending demand for property as 80% of bank loans between July and August were for mortgages. Home prices this past year increased by 16% due to looser lending policies. Overall, in recent years Chinese banks and corporations have been taking irresponsible risks and using excessive leverage, strikingly similar to the US before the 2008 crisis. For China, mounting debt means not only growth slowdown, but also an increased risk of a banking collapse.
Recent news reports have uncovered that bad debt in China is ten times higher than officially reported and growing faster than GDP. Concerned investors in China and abroad accuse domestic policy makers of not doing enough to control this debt growth out of government hunger for sustaining growth. China, terrified of collapse, has decided to pump more cash into the economy to buy itself time, which is feeding the colossal debt. While a stimulus plan may have been necessary directly after the 2008 crisis, the continuation of artificial growth through the government is not sustainable in the long term. Kyle Bass, famous for betting against the subprime mortgages before the 2008 economic crash, forecasts that due to the banking sector’s rise to 340% of China’s GDP, a banking failure will lead to losses four times that of the US in 2008. Foreign banks who have been lending excessively to Chinese borrowers in the past are now scaling back significantly because of the concerning credit-fueled model, and American banks have stepped away from China’s economy in reaction to the recent slowdown. In June Goldman Sachs reported on the danger of China’s credit issues and sustainability risks. Now just a few months later, they have decided to cut nearly a third of their investment banking staff in Asia. Other banks such as Barclays and Deutsche Bank have also discussed plans for reducing operations in the area, indicating foreign banks’ skepticism of China’s financial security and the effect it could have on developed economies.
Realistic or Pessimistic?
While China’s economic slump has caused speculation, the actual likelihood that the debt crisis would result in a global meltdown similar to the US housing market collapse is slim. Firstly, China’s financial system is dramatically different from that of the United States. Not only are all the major banks of China under government control, but they all have low default risk ratings and low levels of foreign currency debt. Having control of these banks allows the government to reallocate funds towards banks at risk. Secondly, corporate debt makes up $18 trillion of China’s debt with assets totaling 552% of GDP. These can be sold off and used to repay loans to reduce mounting debt. Finally, China’s mortgage market is far more controlled than the US. Homebuyers pay significant down payments of at least 35% when purchasing a home. The government also can exercise control in this sector through mortgage policies, tax rates and housing purchase restrictions.
Although China’s debt is growing rapidly, its debt to GDP ratio is around 250%, which is not nearly as high as the US at 331%. So although the situation is not the same as the 2008 collapse, investors have valid reason to be concerned. If China can’t find an alternative to using credit to fuel the economy, growth will lag and the banks will be far more vulnerable to liquidity shocks. The system needs restructuring and the implementation of austere measures, even if it means sacrificing growth in order to protect the entire economy. China has released a proposal for cutting company debt through an increase in mergers and acquisitions, bankruptcies and debt securitization. It’s clear the central bank is prepared to make monetary policy work for debt reduction. Although these measures are likely diverting a crisis, China’s government must consider economic reforms for long term sustainability. The debt has reached a level where increasing artificial growth will no longer stimulate the economy but will have devastating effects. The solution will only come when a sector of China absorbs the cost of debt and, unless the government wants to put the housing sector at risk of failure, it must take control and pay the cost—nearly a third of GDP. With much of the global economy dependent on China, a state whose government has full control of its economy and finances, the West should be expressing more concern.
The views expressed by the author do not necessarily reflect those of the Glimpse from the Globe staff, editors or governors.