The Chinese Debt Bubble

A number of people think that the next big shock for the global economy will be the bursting of a Chinese debt bubble. Let's take a look.

There's an old joke that if you put five economists in a room to discuss a subject, you'll end up with ten different conclusions. The "dismal science," as Keynes described it, is adept at vagueness. So, when it comes to the Chinese debt bubble, you won't be surprised to know that there are about as many economists who think that one does exist, as those that think one does not exist.

The problem comes from lack of quality data, and that what data exists is very opaque. According to the Bank for International Settlements, China's total credit to the non-financial sector as a percentage of Gross Domestic Product (GDP) reached 257 per cent in 2017. That sounds very high, but compare that to the U.S. at 249%, the UK at 281% and Japan at 373%. If China's got a debt bubble, it's got company. In fact, some economists take the view that there is nothing wrong with countries with high savings rates (like China) having high debt-to-GDP ratios. Their view is that because savings are transformed into investment (debt) via the banking system, a country with high savings will inevitably have higher levels of credit creation. Other economists point out that China has a $1 trillion mountain of bad debts that, once written-off, will bring down the economy in a crash. They allude to accounting tricks within corporations who each have cross-debt holdings in order to window-dress the true situation. Who to believe?

Well, one thing is consistent across all debt bubbles. Where a debt bubble exists, the financial sector in that economy performs well. And it's not just banks that should be included in that definition. In the U.S. debt / real estate bubble during the mid-noughties, the so-called shadow banking sector came to prominence. So pervasive was the clamor for debt that the traditional form of finance through banks was by-passed in favor of all-sorts of weird and wonderful methods of raising debt, and via the broader financial services sector. This is what is happening in China now. More onerous rules and regulations on banks have only encouraged individuals and corporations to seek their fix from other financial "institutions." The financial sector as a whole is benefitting. So, there could be one way to identify if a Chinese debt bubble (whether it exists or not) is about to burst.

The top panel of our chart below shows the relative performance of the Chinese financial sector, as defined by the ratio of the FTSE China A 600 Financial Services index to the overall market. As we can see, the ratio is towards the top end of this history going back to 2002, indicating that the Chinese financial sector is doing relatively well.

The lower panel of the chart shows the relative performance of the U.S. financial sector, as defined by the ratio of the S&P 500 Financials index to the overall market. Notice how U.S. financials actually topped out in relative terms at the start of 2004! The bubble took a few more years to burst but that relative high was never beaten. Even though the U.S financial sector was in its heyday between 2004 and 2007, the relative performance was indicating that the glory days were already fading away before the big crash came. Indeed, note the accelerating downtrend in relative performance during 2007, a year before the "shock" of October 2008.

Now take a look back at the Chinese financials chart. A relative performance top there was established at the end of 2014 which, also, has not (at this juncture) been beaten. Is it possible that market pricing is, once again, giving us a lead indicator that a financial sector is coming off the boil?

Getting back to our five economists then, there are arguments for and against a debt bubble existing in China. To be brutally honest, nobody knows. Nevertheless, we find it interesting that there is a financial sector set up in China now, similar to that in the U.S. a decade ago. Both financial sectors show strong performance relative to the overall market, but both relative highs are lower than the previous peak.

In conclusion, if there is a debt bubble in China, and if it is going to burst, we can be quite confident that the relative performance of the financial sector will start to deteriorate long before it becomes news. Keeping a close eye on that metric therefore is crucial, and you can keep up-to-date with its development here at

China financial sector relative to overall market

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