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The World's Debt Is Alarmingly High. But Is It Contagious?
Welcome back to a familiar anxiety: global debt contagion.
Matthew Philips matthewaphilips
February 22, 2016 9:25 PM IST
Photographer: Qilai Shen/Bloomberg
One of the loudest creaking sounds coming from the markets right now is the
global economy straining under a record pile of debt. The world has continued to borrow
hand over fist since the financial crisis, adding nearly $60 trillion since 2007 in the
process of pushing the worldwide debt load to $200 trillion, or nearly three times the size
of the entire global economy. And that figure takes us only to 2014; we don't yet have
fresh debt tallies from last year.
Hard data are often hard to find and arrives late. But no matter how you measure, global
debt levels are raising alarms over whether we're on the brink of another debt-fueled
economic meltdown. The potential for disaster depends on how contagious a new round
of defaults would prove and whether writedowns in one part of the world could cause
losses in others. That's what happened in the last two major debt crises, which rippled
through the global economy.
In the late 1990s, ballooning sovereign debt loads in Indonesia, Thailand, and South
Korea, combined with a default by the Russian government, kicked off back-to-back debt
crises in emerging economies that required serious bailouts. Another cascade in 2008 saw
the U.S. subprime bust metastasize into the worst economic downturn since the Great
Depression, infecting Europe with a sovereign debt crisis along the way.
This is why everyone is so worried about China
After the 2008 financial crisis, investors poured money into China, Brazil, and other
emerging markets to take advantage of recovering commodity prices and faster-growing
economies. Banks in these places turned on the spigots and unleashed a wave of new
credit to households and local companies. Since 2009, the average level of private debt in
emerging economies has gone from 75 percent of GDP to 125 percent, according to the
Bank for International Settlements. Private debt levels in China and Brazil are now
double the size of the national economy.
A trio of recent slides from the from the Bank for International Settlements is particularly
eye-popping:

The hand-wringing right now concerns mostly China's debt, which has tripled since 2009
from $10 trillion to $30 trillion, according to McKinsey's latest estimates. The biggest
increases are in China's corporate sector, where big state-owned companies gobbled up
loans from big state-owned banks. Hedge fund billionaire Kyle Bass, who made a
fortune betting against the U.S. subprime crisis, is telling his investors that China's stateowned banks may take losses upward of $3.5 trillionfour times more than what U.S.
banks got hit with during the 2008 financial crisis.
Yet lending in China continues to set records. In January, for instance, the
broadest measure of credit in the country soared past expectations as banks front-loaded
their 2016 lending targets in hopes of goosing short-term growth. The trouble is that no
matter how much credit gets added to its economy, China's slowdown is inevitable.
Adding leverage to an already leveraged system may only make the reckoning more
painful.
Would a Chinese debt crisis be highly contagious?
In the traditional sense, perhaps not as much as we might think. "The levers for direct
contagion have never really been there with China," says Harry Broadman, a senior
fellow at Johns Hopkins University's Foreign Policy Institute and a former economist at
the World Bank.

In Broadman's view, the financial mechanisms that tend to transmit default risks across
economies are not as apparent. The yuan is still not fully convertible, and most of the
debt in China is held in local currency, which minimizes foreign exchange risks that were
such a problem during the Asian crisis in the 1990s.
Most of China's borrowing also takes place through traditional bank loans, rather than
through the bond market. While bonds can spread out the pain of a default or a souring
credit situation among lots of investors, they also raise the risk of contagion by creating
more interconnections with outside investors.
Whatever happens, it won't be 2008 all over again
That's not to say that the rest of the world is shielded from the risks of China's growing
debt bomb. On the contrary, the dangers have been plain to see as worries over slowing
economic growth led to an historically bad start to the year for stocks. The risk isn't a
debt implosionit's continued slow growth as China focuses more resources on
managing its debt rather than trying to reform or grow.
"You shouldn't think, 'Oh my God, this is all going to collapse and China is going to
default on itself,'" says Derek Scissors, a China expert at the American Enterprise
Institute. "Instead, you should think, 'Oh my God, what a colossal waste of money.'"
So long as China's government is willing to backstop the country's banking systemand
so far all indications are that it isthere's little chance of liquidity freezing up like it did
in the fall of 2008 when U.S. banks started running out of money. Short sellers also can't
attack Chinese banks the way they went after Lehman Brothers when it was teetering on
the brink.
One of the lessons of the 2008 crisis was that the U.S. financial system was only as
strong as its weakest links: highly-leveraged banks and insurance companies such as
AIG. The opposite is true in China, says Scissors, where all that matters is the willingness

of the state to offer support: "As soon as a bank or a company looks at risk, the
government will just swoop in. So it's the strongest link that matters." The problem, he
says, is that China ends up pouring good money after bad, rather than investing in
growth.
China's rising debt and slowing growth have also effected its appetite for U.S.
Treasuries. For years the country stocked its surpluses into the safety of U.S. debt. Now
that those surpluses aren't as big, China's been reducing its holdings in Treasuries.
What about all that debt everywhere else?
As for the rest of the emerging market, where debt has risen the fastest, there are other
reasons to be cautiously optimistic about a debt contagion being kept in check. For one,
more countries have floating exchange rates than in the past, giving them the flexibility to
devalue in the face of a rising U.S. dollar. "That's made a tremendous difference," says
Kenneth Rogoff, an economist at Harvard who has written extensively on the nature of
debt. "In my opinion, floating exchange rates are the only reason Russia and Brazil
haven't had a financial crisis yet."
These countries also hold a lot less dollar-denominated debt than in previous
cycles. That's not to say a lot of borrowed dollars aren't out there that could go sour.
Plenty of companies in the emerging world that took out loans in dollars yet earn in their
local currencies. When the dollar was cheap, that made sense. But as the dollar has
strengthened, those loans put the squeeze on a lot of companies by raising the value of
their debt against the value of their revenues. According to data from the BIS, the amount
of U.S. dollar debt held by nonbanks in emerging economies stayed flat at $3.3 trillion
from June to September last yearthe first time since 2009 that metric hasn't risen. It
might just be evidence that companies are at least wising up.
At least we don't need to worry about one old debt nemesis
Any attempt to forecast the risk of global debt crisis wouldn't be complete without
revisiting one of the main culprits from 2008: the dreaded credit-default swap.
Initially designed as a way for banks to spread risk and free up capital instead of holding
it in reserve to protect against losses, the CDS was a brilliant financial innovation. But by
the eve of the financial crisis, they were everywhere, hiding on the balance sheets of
companies and creating unknown pathways of infection all over the world. When AIG
was bailed out, it held $440 billion of credit-default swaps on its books. By 2008, there
were $60 trillion worth of these credit derivatives around the world.
Today, the total CDS market is a fraction of that inflated size, having steadily shrunk
down to $16 trillion by the end of 2014, according to the Bank of International
Settlements. Things may still go bad, but, like always, whatever goes wrong will be
different from the last time.

http://www.bloomberg.com/quicktake/china-economy-reform?terminal=true

Here are some of Chinas economic pain points: bloated state-owned companies; banks
with rising bad loans and local governments drowning in debt; massive overcapacity in
the property market; bad investment in the wrong places. Thats just what hurts now.
Here are some chronic headaches: an aging population; a wide wealth gap; a lack
of innovation that could make it hard for China to improve the lives of its middle-income
citizens the way it lifted hundreds of millions out of poverty; underfunded health and
pension systems; environmental degradation; water shortages; corruption; rigged courts.
Add to all that a roller coaster stock market that lost $5 trillion last summer. Nobody
knows all this better than Chinas leaders, who have issued a raft of policies to deal with
the problems arising from the countrys economic maturation. Its not clear how far they
are willing to go to fix the system or stay out of the way and let it fix itself.

The Situation
Under President Xi Jinping, Chinas leaders are pushing ahead with dozens of
remedies. The changes range from abandoning the one-child policy to signaling that a
lower target for economic growth is sufficient to meet goals. They are also cracking down
on bribe-taking and speeding up steps to make the currency more freely tradable.
Altogether they constitute the biggest policy shifts since at least the 1990s. How fast the
changes will come is another question. Chinas reform goals were left vague when first
unveiled in 2013, allowing plenty of leeway for delays and results that fall short of
expectations. Two contradictory objectives have remained clear: ensuring the partys
control and right to govern, while transitioning from an economy reliant on exports and
infrastructure investment to one fueled by domestic consumption and the guiding hand of
the market. Chinas epic stock market boom and bust in 2015 showed its leaders
frantically shifting course. When the government intervened to support prices, the
fiddling tarnished the idea that China is ready to relax the guiding hand of the state.
Why China's Economy Will Be So Hard to Fix
http://www.bloomberg.com/view/quicktake/china-economy-reform
Video: https://www.bloomberg.com/api/embed/iframe?id=b0ad4cb2-d44a-4df3bde5-31c96bb28f2f" allowscriptaccess="always" frameborder="0"></iframe>

The Background
China completed a once-a-decade transfer of power to a new generation of leaders at the
2013 National Peoples Congress after what many saw as a decade of inaction under
President Hu Jintao and Premier Wen Jiabao. Xi and Premier Li Keqiang have offered
bold plans to control local-government debt, strengthen environmental protection and
reform state-owned enterprises. Yet making those goals a reality has been a challenge. It
doesnt help that Chinas economic growth slowed to 6.9 percent in 2015, the weakest
pace since 1990. The first default by a state-owned company in April 2015 signaled some
willingness to let market forces take their course. Done right, Chinas leaders may be
putting the economy on the path to surpassing the U.S. as the worlds largest. On the
other hand, the consequences for the world could be dire if China doesnt manage to
eliminate overcapacity in sectors such as steel and focus more on the quality of economic
growth than on hitting prescribed annual targets.

Source: National Bureau of Statistics of China

The Argument
There are many factions inside Chinas one-party state, including vested interests with a
stake in preserving the system. Some want reforms like exchange-rate liberalization and a
breakup of state monopolies. Others prefer more government control. Big state-owned
companies and the families of communist leaders want to maintain benefits they have
built up over the years. Local officials dont always obey the central government because
they have their own incentives to do what they think is best for their careers and their
localities. Propping up the stock market added to suspicions that China is still reluctant to
turn its back on a Soviet-style controlled economy. Theres danger for the party in doing
too much or too little, in alienating domestic allies on the one hand or provoking capital

flight if the economy or markets founder on the other. The added complication now is
that the Internet, while controlled, has given voice to hundreds of millions of people,
many of whom are clamoring for relief from pollution, corruption, injustice and
inequality.

The Reference Shelf

A Bloomberg News 2016 series: Why It's Impossible to Talk About Just One
Chinese Economy.
The World Bank and Development Research Centers 2012 report China 2030.
Bloomberg News article on Xi Jinpings progress on economic reforms.
The Hoover Institutions China Leadership Monitor.
Official government website for the Communist Party in English.
International Monetary Fund China page and report on its 2013 consultation with
China.
McKinsey reports: Whats Next for China.
A series of Bloomberg QuickTakes explore Chinas challenges, including its
struggles with air pollution, the debt bomb, currency liberalization and managed
markets.

To receive a free monthly QuickTake newsletter, sign up at

bloombergbriefs.com/quicktake
First published Nov. 12, 2013
To contact the editors responsible for this QuickTake:
Nick Wadhams at nwadhams@bloomberg.net
Grant Clark at gclark@bloomberg.net