The key chart
Trends in “excess credit growth” in China since December 2012 (Source: BIS; CMMP)
The key message
“The Chinese government knows that there is a disease called balance sheet recession, and they should know how to handle it”
Richard Koo, quoted by Bloomberg on 10 July 2023
Richard Koo is the Chief Economist at the Nomura Research Institute who developed the concept of “balance sheet recessions”. These recessions occur when “a nationwide asset bubble financed by debt bursts” (Koo, 2008). According to a Bloomberg article this week, “Koo’s ideas are being taken seriously in China”.
In this post, I explain why this is the case. I revisit my January 2023 arguments and update the data points and charts from “The missing link in the China re-opening story?”. I begin with the same question that I posed at the start of the year:
What happens if rather than seeking to maximise profit/utility as traditional economics assumes, the Chinese private sector (PS) turns to minimising debt or maximising savings instead? What if China experiences a balance sheet recession?
What does the data tell us?
While China’s PS indebtedness has declined from its 3Q20 peak, it remains above Japan’s “peak-bubble” level. Affordability risks remain elevated in China too. The PS debt ratio is not only high in absolute terms, but it is also elevated in relation to its long-term average. Chinese debt dynamics have shifted from excess growth in corporate credit growth, through excess growth in household debt, to a “passive deleveraging” phase. The risk remains that this extends to full PS debt minimisation i.e., a balance sheet recession.
Following recent re-intermediation, the Chinese banking sector is relatively exposed to the risks associated with these dynamics. The bank sector debt ratio exceeds the level reached at the height of the Spanish private sector debt bubble, for example, and is currently the highest ratio among BIS reporting economies.
What are the implications?
China’s debt dynamics point to potential demand (debt minimisation) and supply side (bank sector debt) constraints to future consumption.
From a policy perspective, Koo argues that the Chinese government must ramp up spending to offset private sector deleveraging. According to Bloomberg, he recommends a fresh wave of fiscal stimulus, targeted towards the real estate sector.
From an investment perspective, these factors need to be included in the investment narrative. It was a mistake to ignore private sector debt dynamics at the start of the year. It is a mistake to ignore them now…
Why is Richard Koo’s profile rising in China?
Personal background
I met Richard Koo in Tokyo when I was a graduate trainee at Nomura Securities in 1986. I left Nomura in 1988 to build the top-rated Japanese equities team (for European clients) at Baring Securities. I subsequently moved on from Japanese equities in the early 1990s to develop a career in banks research and macro strategy. I continued to follow Koo’s work, read his books and applied his approaches to my own analysis of monetary and macro developments in other advanced and emerging economies. We share a common analytical foundation based on a sector-balances framework.
My January 2023 message
In January 2023, I questioned the so-called “China re-opening” narrative. My scepticism centred on the level of Chinese private sector debt, the growth in HH debt and the affordability of private sector debt.
I asked, “What happens, for example, if rather than seeking to maximise profit/utility as traditional economics assumes, the Chinese private sector turns to minimising debt or maximising savings instead? What if China experiences a balance sheet recession?”
The July 2023 update
Trends in Japanese, Spanish and Chinese PS debt ratios since 1980 (Source: BIS; CMMP)
China’s private sector indebtedness exceeds the “peak-bubble” level seen in Japan in 4Q94. The private sector debt ratio was 220% GDP at the end of 4Q22, below its recent 225% peak but still above Japan’s peak debt ratio of 214% GDP. Note the similarity in debt ratio trends in Japan (debt bubble), Spain (debt bubble) and in China (see chart above). History rhymes…
Trend in the Chinese PS debt service ratio since 2000 (Source: BIS; CMMP)
Private sector affordability risks remain elevated too. The private sector debt service ratio (PS DSR) is not only elevated in absolute terms (20.6%) but it is also elevated in relation to its long-term average (15.7%). The PS DSR peaked in 3Q20 (see chart above) and has trended between 20-21% since then.
Trends in stock of HH and NFC debt (RMB tr) and PS debt ratio (% GDP, RHS) (Source: BIS; CMMP)
The Chinese private sector has already entered a period of passive deleveraging (see chart above). In other words, while to outstanding stock of debt continues to increase, it has been growing at a slower pace than nominal GDP since 3Q20.
Chinese debt dynamics have shifted from excess growth in corporate debt to excess credit growth in household debt and then to passive deleveraging. The risks remain that these trends extend to an extended period of private sector debt minimisation – i.e., a balance sheet recession.
Bank credit as a percentage of total PS credit (%) since 2007 (Source: BIS; CMMP)
With recent re-intermediation (see chart above), the Chinese banking sector is relatively exposed to the risks associated with current debt dynamics. The bank sector debt ratio (see chart below) exceeds the level reached at the height of the Spanish private sector debt bubble, for example, and is currently the highest ratio among BIS reporting economies (excluding Hong Kong).
Trends in Japanese, Spanish and Chinese bank sector debt ratios (% GDP) (Source: BIS; CMMP)
Conclusion
China’s debt dynamics point to potential demand (debt minimisation) and supply side (bank sector debt) constraints to future consumption.
From a policy perspective, Koo argues that the Chinese government must ramp up spending to offset private sector deleveraging. According to Bloomberg, he recommends a fresh wave of fiscal stimulus, targeted towards the real estate sector.
From an investment perspective, these factors need to be included in the investment narrative. It was a mistake to ignore private sector debt dynamics at the start of the year. It is a mistake to ignore them now…
Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.