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China's debt crisis: U.S. threat, and opportunity

Richard Vague prescribes for the next big economic downturn

"China, fueled by runaway lending, has produced far more housing, steel, iron, and a host of other goods than it knows what to do with, amassing unprecedented levels of overcapacity and, by my estimate, making a staggering $2-$3 trillion in problem loans in the process," writes Richard Vague, who ran the biggest credit card bank in the company in the late 1990s (First USA) and has since parlayed his consumer-marketing smarts into a career as company founder and seller (EnergyPlus), investor (Gabriel Partners), Philadelphia philanthropist and Washington policy activist, in Democracy Journal here. 

"And since GDP growth is more a measure of capacity being created than capacity actually needed, even China's high rate of GDP growth, fueled almost entirely by continued ultra-high levels of lending growth, compounds rather than solves China's fundamental overcapacity problem," Vague adds. He compares China to the U.S. in the mid-2000s, before the financial crash.

"Which means that the global economic boost from China, the world's only major growth engine since the crash of 2008 in the West, is rapidly diminishing and will soon largely end. The only question is how."

There is nothing "black swan" about financial crises like the U.S. mortgage blow-up of 2008 or the pending China fiscal freeze, adds Vague. "Major financial crises can be anticipated so long as you're on the lookout for the red flag of rapidly rising levels of private debt. If we are to avoid repeating history, we would do well to observe the Chinese predicament, understand its implications for the global economy, and apply lessons to our own economy."

Vague, former head of USA Bank, Barclaycard USA and the West Philly-based electricity retailer EnergyPlus, knows the value of easy money in expanding economic activity and boosting a standard of living for millions. "The problems come when private-debt growth is too rapid or reaches levels that are too high," like Japan in 1991 (commercial real estate loans), the U.S. in 2008 (mortgage loans), and China today (both real estate and industrial loans). And China, Vague concludes, "has amassed the largest buildup of bad debt in history."

He writes: "Good and sound loans, by definition, result in commensurate GDP growth. So when private-loan growth outstrips GDP growth, much of that excess—from one-quarter to one-half, based on evidence from other crises—will be problem loans. Based on this formula, China today is likely to have an estimated $1.75 trillion to $3.5 trillion in problem loans—a figure well in excess of the $1.5 trillion of total capital in China's banking system.

"Of course, China's banks and shadow lenders are not reporting bad loans close to this amount. But neither did U.S. banks: On the eve of the U.S. crisis, banks were making loan-loss provisions at very low levels. Lending booms create the false appearance of prosperity, and fraud and corruption can make the picture even prettier."

Vague acknowledges previous predictions of a China collapse have been wrong. But never has the country's private debt been so large -- more than double GDP, more than the U.S. or Japan in their bubble years. And other countries are no longer, as they were in past crises, eager for large volumes of new China imports, which will make it tougher for China to grow its way out of trouble..

Vague has a rule of thumb he extracted from the data: "A financial meltdown is probably on the horizon if the ratio of private debt to GDP rises by roughly 17 percent or more over the course of five years and exceeds 150 percent." China, he says, has hit both those triggers.

(This parallels one of the guidelines for evaluating financial companies: When loans expand rapidly, watch out: The jump in revenue will likely be followed by a rise in bad loans, losses, foreclosures, bankruptcies. Repeated across many lenders, the result is economic slump.)

When government is the lender or is effectively guaranteeing reckless lenders, the wham is that much bigger. Separately, governments typically boost borrowing -- even as tax income goes down -- to try and restart the economy; that's one of government's roles.

Vague says it's wrong to do as U.S. lawmakers have done and focus too much on government debt: Private debt is what slows economies most obviously. It's government's job to step in and cushion the blow.

"If too much capacity and too many bad loans are the problems, the solutions are time and capital: time for organic growth to absorb the excess capacity, and capital to repair banks and borrowers," Vague adds.

A tough prescription, especially in democratic countries. Maybe China's ruling Communists are still powerful enough to force this bitter medicine and make the nation like it? "China's leaders can prop up their lending system for a time. Even Japan was able to prop up its banks for several years after its stock market collapse," Vague writes.

"What they can likely no longer do, however, is effectively prop up real estate and commodity prices. Over time, because the decline in real estate and commodity prices is evidence of China's overcapacity and those assets are collateral for so much debt," this will weaken China.

What should China do? Vague says it should force banks to "broadly, quickly, and decisively restructure debt with overburdened corporate borrowers—to provide, in other words, real debt relief and restructuring that allows those corporations to resume productive investment, not simply accounting sleight of hand. Otherwise, high debt will linger for years [as in Japan] as a long-term drag on China's economic prospects."

Writedowns are "the surest path to revitalizing its beleaguered business sector, remedying overcapacity issues, stabilizing prices, and restoring reasonable growth. By alleviating rather than simply disguising China's high private-debt-to-GDP problem, it would leave corporations in a much better position to lead renewed (and, hopefully this time, more measured) growth after the slowdown."

Is China's loss America's gain, or will they drag us down, too?

Vague focuses more on what we ought to be learning from their troubles: "Our policy-makers should move beyond the fixation with public debt and turn their attention to the true problem of private debt. They should recognize the inadequacy of the timeworn tools of monetary and fiscal policy and lead a discussion of strategies—especially restructuring—to address the key issue of historically high private-debt levels... Low private debt, combined with low capacity (the supply of housing, factories, etc.), was the precondition for the economic boom we experienced in the post-World War II decades.

"China's downturn will only add to our challenges. The modern world has had four major economic engines—the United States, China, Europe, and Japan—which together constitute 60 percent of world GDP. While the United States moves toward respectable growth, both Europe and Japan—also hobbled with high private debt—are struggling to show any progress.

"But it is China we should be worried about. China is facing a generation of dramatically slower growth. Its slowdown will cause trouble for its trading partners and lenders across the globe. And while the economic impact in the United States will be softer than in any other major country, China is now so large that we too will feel it." We should learn from it and avoid the same mistakes by keeping our own lenders from again going too far, Vague concludes.