A few months ago, Capital Flywheels penned two posts arguing why the popular understanding of the USD and monetary easing were problematic and likely incorrect.
In “In Dollar We Trust (and Why China Would Prefer Otherwise)“, I argued that the USD position as a global reserve currency is much stronger compared to reserve currencies of the past. And as much as China would like to get off the dollar standard, the hurdle is much higher today because the nature of currencies and capital markets have changed.
In “24/7 Money Printing at the Fed? Misconceptions and Consequences.“, I argued that most people misunderstand monetary easing and how it is carried out. And this misunderstanding is the primary reason why hyperinflation has not appeared. And anyone investing (*cough*…gambling…*cough*) based on these misunderstandings will likely achieve suboptimal outcomes. For example, despite gold’s recent strong run, it has barely returned back to its 2011 price peak, despite a decade of unprecedented monetary easing across the globe. Many argued that gold is THE investment you want to hold in an unlimited “money printing” world…yet, gold has been a suboptimal investment1. Gold investors do not understand how monetary easing works, and, as a result, do not understand why we don’t have inflation.
Today, Capital Flywheels would like to tackle a third major misunderstanding – China’s capital sustainability.
Over the years, Capital Flywheels has interacted with a lot of investors and experts on this topic. Generally, western practitioners tend to view China’s capital situation skeptically. Because we hear about things like massive ghost town construction projects and cannot fathom how this makes any sense. While the Chinese certainly have a variety of opinions on this very topic as well, the Chinese tend to think it’s more sustainable than westerners assume.
Capital Flywheels’ view is closer to the Chinese’ view, but Capital Flywheels believes both sides are not using the right lens to understand China’s capital trajectory and ultimate sustainability of the situation.
Let’s start with the westerners’ view.
China has a lot of debt…China’s total debt-to-GDP ratio is now >300% and has risen at a remarkable pace after 2008. The China “miracle” over the last decade is as much a result of astute government planning as well as massive debt-driven stimulus. China’s debt-to-GDP has approximately doubled since 2008 during a period in which GDP has gone up 3x (from ~$4.5 trillion in 2008 to ~$14 trillion in 2019). This means that total debt has risen almost 6x in total.
This is an extremely high level of debt and extremely fast level of debt growth.
There is only one other major economy that has a materially higher level of debt – Japan.
Source: The Institute of International Finance (IIF)
China’s debt-to-GDP ratio has reached levels only seen by other developed economies (and other highly developed emerging markets such as Singapore and Korea).
Excluding highly developed emerging market countries, the emerging markets tend to break when debt-to-GDP starts to exceed the 100-150% level.
However, not all debt is created equal, though. Unlike the US where households, corporates, and the government all have sizable debt balances, China’s debt is primarily contained within the corporate sector.
While China has very high total debt, the government’s debt balance is actually very manageable at just under 60% of GDP (whereas the US is now around 120% of GDP due to Covid-19 expenditures).
This is important because the pricing of all risk within a country is always priced against the sovereign. And if a sovereign is engulfed in a debt crisis, even the safest household and corporate balance sheets within that country will inevitably come under stress. If a sovereign nation has issues borrowing money, even their most creditworthy citizens are unlikely to be able to access credit markets easily. The Eurozone learned this the hard way in 2011.
From this perspective, it’s clear that China’s debt mix is actually quite a bit more sustainable than it appears, especially with respect to other major economies where government debt is a materially larger portion of the mix.
Since all risk is priced against the sovereign, a strong government balance sheet is often a huge benefit for the domestic private sector. It keeps borrowing costs low (all else equal), as well as provides the necessary macro-stability necessary to attract capital for investments.
However, this is not to say that all is well in China. As you know, China’s economy is run very differently from the rest of the world. Comparing China to the rest of the world is often a comparison between apples and oranges. Two major differences need to be taken into account:
1/ A significant portion of “corporate” debt is actually government debt. This is because a very large portion of the Chinese economy is conducted through state-owned corporations (SOEs). While they are corporations in name, they are effectively (at least partially) government-run and financed. Many of these SOEs are not particularly well run, and hence generate low returns on capital. Many SOEs have high debt balances. And ultimately, whether that debt balance is an obligation of the government or not is…debatable. If it does become an obligation of the government, then the sovereign balance sheet would be much weaker.
2/ China’s corporate sector (excluding SOEs), historically, have had a very hard time getting financed. In every economy around the world, the banking / financial system is the primary provider of capital. In China, the banking system is effectively government-run as well since most banks are SOEs. These banks historically have shied away from lending into the private sector, preferring to finance SOEs, which are implicitly assumed to be risk-free (you see…even the banks assume that lending to the SOEs is lending to the government!). As a result, the private sector needed to get creative to find financing. This has led to the creation of large “shadow banking” sector, which is not accurately captured in statistics. In the past, shadow banking has led to excessive rise in leverage in private corporate sector as well as in household sector, which has forced the government to engage in multi-year “whack-a-mole” programs.
As this chart from the macrostrategist, Yardeni, shows, China’s credit (referred to as “social financing”) growth has increasingly shifted away from bank loans and towards shadow banking. The government has gone on two major drives to bring it back under control over the last 5 years, which has contributed to the sharp “teeth” shape of the curve.
All of these items above are fairly well understood by China observers / westerners. While there is heavy debate by westerners on how long this can go on, westerners tend to think China is going to run out of runway soon.
On the Chinese side, the perception is quite different.
This is because the Chinese understand how exceptional their other side of the equation has been.
One cannot understand the sustainability of debt without understanding the income and savings that support it. The Chinese know better than outsiders that the Chinese people save an incredible amount of money. The latest full dataset I can find from OECD is from 2015…back then China saved almost 50% (!) of GDP. In comparison, the US and Japan saves less than 10% of GDP. With such high savings, it shouldn’t be a surprise that China can support very high debt levels. The major reason why the US and Japan can even support such high debt levels at the moment is because the US and Japan also had very high savings rate decades ago before both countries went on massive spending binges over the last 3 decades.
So what has resulted are two sides arguing straight past each other.
There are reasons to think this trajectory is both simultaneously sustainable and simultaneously not.
This is because the total debt-to-GDP is rising whereas the national savings rate is high but not rising.
Saving 40-50% of GDP per year is incredible, but the debt pile is already 300% of GDP and growing faster than GDP. Currently, China’s social financing is growing around 10% per year.
Given that the debt stock is >300% of GDP, 10% growth of social financing is equivalent to ~30-35% of GDP, offsetting most of the national savings. And there are a lot of indications that China’s savings rate has declined since 2015 towards low 40% area.
What this means is that while China’s debt level is sustainable because of its high savings rate, it is unlikely to be able to continue growing anywhere near historical levels. China’s social financing growth will likely need to slow soon in order to avoid entering an unsustainable path.
All that we have discussed so far are fairly well understood, even if both sides of the arguments are not well understood by the same people.
What Capital Flywheels would like to add to the discussion is the conversation about national wealth.
Capital Flywheels agrees that it doesn’t make sense to look at debt without considering income.
However, similar to our own personal balance sheets, it doesn’t make sense to consider only debt and income without considering our assets (wealth).
You, an astute reader, are probably rolling your eyes right about now because Capital Flywheels seems to have anointed himself Captain Obvious. But I assure you there is more to this discussion than just a discussion about relative wealth levels.
But wealth is precisely the place we need to start to understand the full picture.
China is now a very wealthy place…
Chinese households now have $64 trillion of wealth. This is likely an underestimate because Chinese households have more incentives to undercount their wealth, for lack of a better term. While China is very much a capitalist society today, one’s wealth tends to be more sustainable when hidden than flaunted…I would not be surprised if China’s true household wealth is closer to $80-90 trillion.
And note that this chart only shows household wealth. The truth is that in most countries, the corporate sector and public / government sector tends to have no wealth at all. Governments tend to be on a “pay-as-you-go” system and are perpetually in debt (China’s government, on the other hand, does have a net cash position, but ultimately it depends on whether you think SOE debt is government debt or not). On the corporate side, some companies have massive cash positions (e.g. Apple), but overall, the corporate sector across the world has trended towards net debt positions since debt has become quite cheap. And companies have imbibed two decades of poisonous advice from activists that encourage companies to lever up in the name of shareholder returns (something which Capital Flywheels shies away from in the Paper Portfolio).
Therefore, the household sector is likely the cleanest picture of a country’s true balance sheet strength.
From this perspective, it’s clear why the world’s developed economies can support such high debt levels. They have a lot of wealth!
The US may have total debt equivalent to ~350% of GDP (~$70 trillion), but the US has wealth >$100 trillion (the latest US government data shows that it has risen to $119 trillion in 2020).
Similarly, Japan may have $30 trillion of debt, but Japanese wealth is far above that (most of the wealth in the Asia-Pacific chart above is largely in Japan).
Apart from China, there are almost no emerging markets that have wealth levels that are anywhere close to the developed world. Hence, apart from China, investors should be skeptical of any emerging market country with debt levels materially above GDP.
But China is different.
If I have $100k in the bank, of course, it’s not too risky for a bank to lend me $30k to buy a car, even if my income is only $10k.
This is the situation that developed countries and China are in. The debt is high but income is also high and wealth is incredibly high.
However, Capital Flywheels’ believes even this analysis is missing a very important ingredient because it ignores the differences in distribution of wealth and debt.
While the US, Japan, Eurozone, and China all have positive net worth at the country level (more wealth than debt), it is not evenly distributed within the country. Some people hold most of the wealth (and no debt), and some people owe all of the debt and have no wealth.
As a result, even though countries like the US may have a healthy overall balance sheet, the uneven distribution of the debt load is starting to disrupt the functioning of major parts of the economy.
Although wealth distribution is uneven in China, most Chinese tend to be net savers. As a result the debt load is much more evenly balanced. Poor people have much less wealth than the wealthy, but the poor also tend to have commensurately lower debt levels. This is not the case in the US where the poor tend to be highly levered (with credit card and mortgage debt).
The debt distribution of Chinese balance sheets ultimately (likely) make the system far more sustainable than what westerners assume.
Offsetting this, however, is the different structure of wealth in China.
In most of the developed world, the overwhelming share of national wealth comes from financial assets (primarily equities).
This is what average wealth in the US looks like:
Source: Credit Suisse 2019 Global Wealth Report
China, on the other hand, derives close to half of their wealth through real estate. And since this is an average, the financial assets held by the wealthier portions of society, tend to skew the proportions. For the average Chinese citizen, real wealth tends to be the primary source of wealth.
This is what it looks like for China:
Source: Credit Suisse 2019 Global Wealth Report
The distributional and mix differences on both the asset and debt side have very large implications.
In the US, the primary issue is how to direct the wealth held by the few in order to fill in the widening “holes” in the economy created by debt pressures in the lower income parts of society (and for small businesses). Although the US does not have a debt sustainability problem overall, a large portion of the economy is insolvent.
In fact most countries face this problem even though they have positive net worth on paper.
The main tool that western economies have at their disposal is the taxing power of the state. Through taxes, the state can redirect wealth to solve some of these issues.
But the main problem is that capital is borderless. While western developed countries are wealthy, if they try to redirect the wealth too much (through high taxes), they will soon discover that that wealth will no longer sit within their borders. Because wealthy people can easily move their assets to a more friendly country.
This is the ultimate advantage that China has. China’s dominant form of wealth is NOT financial assets, which can escape borders (although this is equally hard in China due to financial capital controls). China’s dominant form of wealth is real estate, which can never escape the taxing power of the state because it is immovable. China currently does not have onerous property taxes like the US, but all else equal, China has greater ability to redirect wealth as-and-when necessary.
Taking that into account, China should have greater debt capacity than western counterparts (perhaps other than the US because the US has something even more powerful, the ability to issue THE global reserve currency), and this is likely more sustainable than western pundits assume.
Capital Flywheels believes that China, US, Europe, and Japan all have high debt levels but all of it can largely be sustained because the wealth of these nations are materially higher than their debt levels. However, in order for the wealth to be accessible, the governments need to be able to tax and direct that wealth. The only country that truly has that capability is China through a combination of capital controls (financial assets cannot escape) and citizen preference for immovable assets.
Capital Flywheels thinks preference for immovable assets is not the smartest long-term positioning, but there is no doubt that preference is a massive advantage for China.
This advantage almost guarantees that China does not have a solvency issue (whereas the US or Japan or Europe could if a large portion of their wealth decides to migrate to New Zealand or the Caymans or a dozen other remote and untouchable islands)…and that the key concern for China is how to prevent liquidity issues.
Given that the wealth of the average person is NOT liquid (real estate is very hard to transact), China needs to continually ensure that the economy has ample liquidity in order to avoid a liquidity crisis spiraling into a solvency crisis.
This juggling act is starting to get challenging, but this is THE primary challenge for the Chinese economy. It is not a solvency issue. It is the need to continually avoid a liquidity issue because the country’s wealth is all tied up in illiquid assets. If they can avoid a liquidity crisis, the wealth of the nation is more than enough to avoid a debt and solvency crisis for a very long time.
Many investors I’ve spoken to over the years cannot understand why liquidity expansion in China has not led to a debt death spiral.
This is fundamentally the wrong question to ask. Investors overwhelmingly seem to misunderstand the problem that China faces. The only problem China faces in the next 5-10 years is not enough liquidity. Debt expansion is actually a side-effect. If China were able to redirect wealth more directly (e.g. through taxes), China would be able to ward off a liquidity crunch without debt expansion. However, China has not figured how to do that well, yet, and hence debt (social financing) expansion is the primary lever. The good thing for China is that wealth is trapped and immovable and therefore they likely have more years to figure this out than bears assume.
Capital Flywheels believes understanding this is very important to understand how money can be made in the coming years and the risks with respect to government actions. In the West, the taxing power of the state is low because capital can flee. As a result, the West has to increasingly rely on regulations to fix the imbalances arising in the economy. These imbalances cannot be easily fixed by just raising taxes because capital will start to leave.
China, on the other hand, does not have this problem. While this makes China’s debt profile much more sustainable than pundits believe, it also means investors (i.e. anyone with liquidity in China) should be on high alert. Capital Flywheels thinks investors in Chinese assets should be increasingly alert to the direct and indirect “taxing” power of the Chinese state in order to redirect wealth and increase liquidity. Liquidity-rich entities in China look like prime targets to me, which, of course, includes Chinese tech companies as well as wealthy individuals. But, maybe there’s no need to overthink it since there’s not much anyone can do about it with capital controls at the border.
1As a matter of fact, back in September of 2011, Capital Flywheels had a heated debate with a Morgan Stanley commodities derivative trader regarding the sustainability of gold. At the time, gold approached $1,900 / oz. The trader argued that with unprecedented money printing, gold was THE investment to make because gold was on its way to $5,000 or $10,000, minimum. Capital Flywheels made a verbal bet (stupidly…a result of youthful feelings of brashness) that gold wouldn’t breach $2,000. Even more stupidly, Capital Flywheels went out and shorted silver on leverage. The bets worked out – Gold began a >33% decline soon after and did not approach $2,000 until a decade later, and Capital Flywheels’ levered silver short returned >100% in less than 3 weeks. However, in hindsight, Capital Flywheels still cannot fathom how much risk was stupidly taken…something that Capital Flywheels shies away from these days.