China's Debt Problem

"Well, we lost a lot of our independence already. We are dependent on China for credit. We are dependent on Middle Eastern countries for energy supplies. And many Americans are dependent on the government for their income, health care, education of their children, food stamps." - Jim DeMint

It is common knowledge that China has enormous capital reserves.  A current estimate is that the government in China is sitting on a foreign exchange reserve of more than $3 trillion.  This money has been deployed into United States treasuries, Euro bonds, gold and many other mainstream investments and it is thought that with this stockpile of cash and reserves that they will be able to manage any kind of economic slowdown without much trouble.

That theory is now being questioned due to the fact that their banking system has shown many structural flaws and Europe, which makes up around 40 percent of all Chinese exports, is struggling.  Both of these are causing a weakness in the balance of payments but aside from that there is the threat that an economic slowdown in China could destabilize its political structure.

As more and more of the Chinese population becomes mobile there is a desire and a demand for living standards to improve.  The only way that this can be achieved is for China to continue to grow at a rate north of 6 percent.  This is an extremely fast clip for a nation as large as China but it was achievable during the last decade due to the cheapness of its labor pool and a weak currency.  Now with the global economic weakness and a rapid increase in labor rates China is being squeezed and this reserve pool looks like it may not be enough.  In addition it is starting to appear that the Chinese currency the renminbi is no longer grossly undervalued and manufacturers around the globe are starting to take notice of this and are repatriating work to their local countries.

In order to shore up growth the government has undertaken numerous infrastructure projects many of which are the equivalent of digging holes and filling them up again.  Airports lie vacant, subways have no traffic and bridges lead to nowhere.  In order to finance this the government has relied heavily on foreign investment but that is beginning to dry up as many of these projects are turning out to be alligators.  During the second quarter China's capital account shrunk by $110 billion as capital fled the country so China is now having to finance these projects itself using its capital reserves.

This is creating another problem as when foreign capital moves into a country it is forced to exchange it for local currency.  This flows into the banking system and results in banks being awash with reserve so it starts to offer loans to locals.  A reverse of this trend shrinks the capital base and results in a contraction of the loan pool.  The issue is that a lot of the loans that were made are turning sour.  Companies that took out the loans are closing down as demand for their goods and services is not keeping up with the ever spiralling debt payments. 

The bulk of these loans were made back in 2008 and are now coming back to haunt the government as a big portion of these loans were made to state owned businesses many of whom are running deep in the red already.  The state will then have to fund these obligations whether it likes it or not and this will have another major drag on its capital base.  In the boom years overcapacity at steel plants and such was considered a necessary requirement to fill expected demand but with this demand gone these investments are turning into a black hole.

Currently the total corporate debt level is at roughly 125 percent of total GDP.  This is up from 110 percent in 2008.  Now the size is not a major problem if the economy can continue to grow at 8 percent and the growth in borrowing slows.  However now that the global economy is stuttering and there is no sign that a recovery is imminent China's reserves are looking very weak and this will have major implications around the globe particularly if they have to start to claw back their massive foreign investment pool.