Philip Lowe RBA
RBA governor Philip Lowe

Philip Lowe, governor of the Reserve Bank of Australia.

The Australian economy dangles by a single thread: the ability of the Chinese government to prevent a financial meltdown. China is in a debt pickle of gargantuan proportions, and Philip Lowe, governor of the Reserve Bank of Australia, made it clear he is deeply concerned.

China’s debt has risen from around 100% of GDP to over 250% in the last two decades. You may consider this especially startling when you consider that its GDP has risen 11-fold over that time. China’s debt is far out of line compared to other developing countries and even more than many developed countries. This rarely ends well.

“The build-up of financial risks like those seen in China is almost always followed by a marked slowdown in GDP growth or a financial crisis,” Lowe said last week in an address to the Australia-China Relations Institute.

A crash or “marked slowdown” in China would be disastrous for Australia. We rely on China to take a share of our merchandise exports equivalent to that taken by Britain in the 1920s. China is our largest source of tourists and our number one market for education exports. 

A Chinese collapse is not necessarily inevitable, Lowe made sure to point out, before presenting a range of ominous facts. Foremost among the gloomy portents was this: “during the big run-up in debt, a lot of bad loans were made.”

A financial crisis normally has bad loans at its heart. Whether the money was loaned to the Greek government or US subprime borrowers, loans that can’t be repaid turn a debt into a disaster.

In the shadows

China’s major banks are regulated tightly. Much lending happens in other places, via an estimated 3500 small institutions and practices such as businesses lending directly to one another. They call this “shadow banking” and it is represented by the pink bars in the above chart. The shadow banking sector has quadrupled its share of a rapidly-growing economy, adding enormous froth and tremendous risk to the market.

Lowe stated China’s debt growth follows the liberalisation of its financial system. “It’s worth recalling that we saw a similar process here in Australia,” he said. “In our case, this did not end well.”

The early ’90s saw two Australian state banks collapse — State Bank of Victoria and State Bank of SA, along with the Pyramid Building Society and several credit unions, all attributable to actions in the decade following deregulation. It is unlikely all those 3500 under-regulated lending institutions are solvent. The question is whether they can be saved and/or closed without causing a panic.

Dodging the crunch

Our only hope is the Chinese government somehow saving the financial system from collapse. The Communist Party is deeply involved in the markets, very powerful and exceedingly motivated to avoid an economic disaster that could undermine its legitimacy.

We need Xi Jinping and his band of economic bureaucrats to prevent China from having its own Lehman Brothers moment. Lehman Brothers — once America’s fifth largest investment bank — collapsed in 2008. It brought down the US financial system and ravaged the global economy.

Lehman’s fall did not come out of the blue. Prior to Lehman failing, the investment bank Bear Stearns also entered extreme difficulty. With some help from the US government, it was taken over by JPMorgan Chase at an extreme discount. Its failure foreshadowed the horror to come.

If China has a Bear Stearns, it might be HNA — a regional airline that turned into a global conglomerate, which now has $94 billion in debt it most likely can’t repay. Its share price has collapsed and it is desperately selling off the assets it acquired worldwide. Chinese banks (of the state-owned variety) are being kind to HNA by lending to it despite its extreme financial strain.

Someone, somewhere is eating the losses made by these rapacious conglomerates, and we better hope their appetite doesn’t wane.

Will communism save us?

History needn’t always repeat if you can learn lessons from it. The US let Lehman go partly because of Bear Stearns. Saving Bear was costly and made some people very unhappy. China has the benefit of more experience — it knows letting Lehman go was a disaster that revealed how awfully interlinked the whole financial system had become.

It’s a funny old situation for market economists. If the market had its way in China we’d see collapses and full-on financial contagion. Our sole source of hope is that the communist government of China is able to meddle in those markets. Here’s hoping they meddle well.