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While we don’t sell much to China directly, its demand drives the prices of commodities, and our economic momentum tends to rise and fall alongside commodity-price changes.
In the years following the Great Recession, China’s voracious appetite for commodities gave our economy a powerful boost, which helped offset the loss of export demand from U.S. markets. But Chinese GDP growth rates of 10%+ are long gone, and even China’s current stated GDP growth rate of about 6.5% is open to question.
China’s slowing growth hasn’t come as a surprise to its policy makers. They are trying to transition their economy from one that is primarily driven by infrastructure spending and export-manufacturing, to one that is fuelled by domestic consumer spending and is focused on the rapid expansion of the country’s service-based sectors.
This is a monumental task for the world’s second largest economy, and the economic disruptions that are inevitable with such a transition increase the potential for social and political instability. China’s leaders value stability above all else and they have relied on a massive expansion in corporate debt to buffer against potential disruptions. But this has triggered a sharp rise in non-productive debt that provides only stop-gap relief, and that may well exacerbate instability risks over the longer term by delaying painful (but much needed) changes, and by limiting China’s future flexibility.
Here are some highlights to give you a sense of the scope and scale of China’s unprecedented levels of debt expansion:
- China’s debt-to-GDP ratio has increased from 150% to somewhere in the 240% to 270% range over the past decade.
- Chinese debt is expanding at twice the rate of its economic growth (and that’s using official statistics, which should be taken with a healthy dose of scepticism).
- In a recent article, The Economist estimated that roughly two-fifths of China’s new debt issued is needed just to pay the interest on existing loans.
- The same article explained that the more China’s debt grows, the less stimulus it provides to the Chinese economy. Ten years ago it was estimated that one yuan of Chinese debt would create one yuan of additional GDP. Today, it now takes four yuan of new debt to achieve the same one yuan of GDP growth.
- The bulk of China’s debt expansion has been in corporate debt, which has skyrocketed to 165% of Chinese GDP and is now well above the levels seen in most developed countries. Much of this debt has been used to prop up companies that would have otherwise failed, as Japan did in the 1990s. Then, Japanese policy makers used precious resources to keep “zombie companies” on life support, choking off economic growth which has still not returned to that country decades later.
Most worrying is that China’s massive debt expansion has corresponded with declining GDP growth rates that are now in the 6.5% range (if you believe the official data). What will happen to Chinese growth rates if its debt were to stop expanding? We may be about to find out because just last week Chinese policy makers addressed concerns about its rapidly rising debt levels, warning that “A tree cannot grow up to the sky – high leverage will definitely lead to high risks.”
From a Canadian perspective, slowing Chinese growth puts downward pressure on commodity prices, turning what was once a powerful tailwind for our economy into a strong headwind instead. If that causes our economic momentum to slow, it should help keep our mortgage rates at or near today’s levels, although that would provide only a thin silver lining in the clouds overhanging our economic days ahead.
Sidebar: Strange as it may first seem, I think there is a parallel lesson to be learned between the tragic fires in Fort McMurray and an economic-policy mistake that is being repeated around the world.
When talking about the severity of the Fort Mac fires, experts have said that its ferocity was exacerbated by our long-standing policy of extinguishing small forest fires that are part of nature’s way of managing our environment. When we extinguish these fires, we solve a small and relatively short-term problem, but we increase the supply of dead wood for a much larger and more dangerous problem in future.
In that sense, economies are exactly like forests. They require periodic disruptions to remain healthy. My post today describes how China has been using massive debt increases to avoid short-term pain, but in doing so, this country has greatly increased the potential scope and size of its long-term pain to come. Economic disruption is inevitable when the world’s second largest economy is undergoing such a profound transition, and I think history will show that it would have been better for China to have let its small fires burn.
Most western governments and central banks are guilty of using increasingly radical forms of monetary policy to put off short-term pain, and to kick the can down the road a little further. These measures have been effective, at least to some extent, in putting out the small fires. But over the long run, the rules of economics can’t be overcome any more than the laws of nature can.
Five-year Government of Canada bond yields fell by five basis points last week, closing at 0.68% on Friday. Five-year fixed-rate mortgages are available in the 2.39% to 2.59% range, depending on the terms and conditions that are important to you, and five-year fixed-rate pre-approvals are offered at around 2.79%.
Five-year variable-rate mortgages are available in the prime minus 0.30% to prime minus 0.40% range, which translates into rates of 2.30% to 2.40% using today’s prime rate of 2.70%.
The Bottom Line: Midwifing the world’s second largest economy through a dramatic economic transition is a monumental task. China’s policy makers have used an unprecedented level of corporate-debt expansion in an effort to minimize instability risks, but this excessive debt is choking off growth. Slowing Chinese growth will put downward pressure on commodity prices, creating a powerful headwind for our economy that should help keep our mortgage rates low, but in a be-careful-what-you-wish-for kind of way.