Debt crisis in China as domestic stress rises

November 1, 2011

 

No, not the U.S. federal budget deficit or the situation in Europe. The “debt crisis” I’m referring to could have a major impact on our profitability as it affects the largest supplier of goods for resale to the United States: China. Yes, there is a debt crisis in China.

With a population of nearly 1.34 billion people spread across 3.7 million square miles, managing China is no easy task. Over the past 10 years, Chinese cities have seen a tremendous population boom as people from the country moved in search of economic opportunity. In 1978, approximately 17 percent of the population lived in urban areas. Today, nearly half the population lives in urban areas. The scale and speed of this urbanization is unprecedented. While this has helped shape China’s economic rise, it has also taken a tremendous toll on municipal governments. Managing this growth through the expansion of services and infrastructure has cost a great deal of money. They obtained the money by borrowing it, how original! Unfortunately almost everything in China measures in billions and trillions and not always in a positive way.

According to a study, local governments in China owe the equivalent of an estimated $1.5 to $2.1 trillion U.S. dollars. This debt burden is putting tremendous pressure on local governments across China. Interest payments alone total $7 billion to $10 billion per month. The problem is so substantial that it is unlikely any tax increases and the sale of government-owned land to private investors can resolve the mounting problem.

As China’s domestic financial stress levels continue to rise, China will realize that its financial dominance and market manipulations will eventually require hard choices and sacrifices.

The need to grow at all costs has created a bubble with a very thin lining. Local and national Chinese banks are due the majority of this money, which makes matters worse. Municipal governments could soon start violating loan covenants or missing payments outright. This will negatively impact the financial integrity of banks as seen in the U.S. and Europe once these banks stop receiving what they are due. As banks weaken, depositors may worry that their money is at risk and go to withdraw it. This could cause an emotional run on banks, with banks freezing or slowing lending to other customers in order to preserve their capital.

This has all the ingredients of a crisis in the making. The Chinese government will most likely have to step in and offer some type of support to the banking sector as well as to local municipal governments. This has two important implications for U.S. businesses:

#1 – Without doubt, the cost of doing business for Chinese companies will increase significantly.

As banks start to lose money on their government loans, they will try to compensate for this by increasing fees and rates to business customers; just as we have seen happen in the U.S. This will lead to an increase in prices, which means your cost for goods from China will also go up. In the most optimistic circumstances, we may realize an increased migration of Chinese manufacturing to the United States, creating new jobs here at home.

#2- The Chinese government may redirect hundreds of billions of dollars – in China.

In essence, reduced purchases of U.S. Treasury securities, European sovereign debt and other investments which have helped keep the global economy functioning. This will increase the already-risky situation around the world, as the money the United States and Europe need to borrow to keep their debt-ridden governments functioning may dissipate. As an investment, the yields would hardly attract such cash-heavy firms as Berkshire Hathaway or Apple.

The Chinese government has the liquidity and resources to address this problem successfully. But countries dependent on Chinese capital will feel the impact. Sooner or later, U.S. companies will feel the effects of this crisis, forcing most to look nationally for solutions. This offers the benefits of U.S. employment and economic foundations growth, creating long-term, stable and predictable results.
“Gain may be temporary and uncertain; but ever while you live, expense is constant and certain: and it is easier to build two chimneys than to keep one in fuel”.

Benjamin Franklin

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