De-leverage, Re-leverage, Greek Debt Crisis, and China’s House Bubble

By Scott Zhou, Shanghai
20 March 2010

The Greek debt crisis has flared again with the recurrent German reluctance to throw EU money at it, so that shadow still looms. But whether the Greeks or whoever achieves redemption, Europe’s and the US economy are staring at long-term low growth.

In 2008-2009, the US and other developed countries have struggled to boost their own financial, market and economic sectors. Much of the problem stems from the de-leveraging in the private sector supported by re-leveraging in public finance. Debt crises have emerged one after another, in Iceland, Dubai, and lately Greece. High fiscal deficits and government debt burdens in most developed economies are increasingly heavy. The European and US economies are in danger of sliding into a “Japanese-style” rut.

Economist Carmen Reinhart from the University of Maryland and Harvard University professor and former IMF Chief Economist Kenneth Rogoff state in their recent work, This Time It’s Different, that government debt of 90% of GDP is the critical point. In developed economies, if the government debt/GDP ratio is higher than the critical point, the economic growth of this country will be two percentage points lower than that of a country with the ratio lower than the critical point. They have studies the history of the past eight centuries to prove that government’s high debt affects economic growth

Japan, with a debt-to-GDP ratio of over 200%, is a good example. The proportion of budget deficit in GDP of many European countries exceeds 10%, and government debt accounts for more than 90% of GDP. These countries are caught in a low growth plight. The ratio of current government debt of the US in GDP has reached 84%, close to the critical point. The long term view is very pessimistic. The pressure in Europe of an aging population on public finances is increasing, while social security liabilities in the US are also growing.

Deleveraging in European and US private sectors passes to China through contracting imports and pushes re-leveraging in China’s public finance, mostly by local governments rather than the central government. The China International Capital Corporation reports that the loan balance (excluding notes) of the finance platform in local governments by the end of 2009 was about 7.2 trillion yuan, with 3 trillion yuan net newly added, and it is expected to reach 10 trillion yuan by the end of 2011, nearly one-third of GDP in 2009, equivalent to 70% of China’s foreign exchange reserves.

Central government finance, by contrast, is healthy. The ratio of the government’s bond balance to GDP was about 18% in 2009, and the deficit-to-GDP ratio was about 2.2%. Even if debts of local governments eventually go bad or are picked up by the central government, China’s public finance is in far better shape than those of developed countries.

As usual, this is not the whole story. As most local governments in China have adopted operations such as loans-construction-land-selling-repayment, local government debt will inevitably lead to ever increasing land prices and, finally, housing prices, even as local governments have to introduce more “affordable housing” policies.

The economies of China, Europe and the US are strangely but increasingly intricately connected. Large-scale deleveraging by US consumers, financial institutions, and corporations has exacerbated financial crisis, economic recession and the contraction of international trade. To stimulate their economies, developed countries have resorted to large-scale intervention via high government leverage. China has taken a similar route to stimulate its own economy to make up for weak export performance. The serious imbalance of fiscal authority between the central and local governments, and the lacking of local governments of the right to issue debt, has forced local governments into the high-leverage game and expanding real estate bubbles through excessive housing price manipulation, the so called “land management”, and large-scale bank borrowing.

Rogoff has warned that within ten years China will face a debt crisis, and economic growth will fall to 2%. It sounds threatening in the short term but needs attention in the long run. Increasing debts incur lots of trouble.


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