New Debt Danger

Earlier this year it looked as if we’d got past the worst of the 2008 debt crisis, but recently fears have been rising again. The main driver has been the issues in the Eurozone, where a version of quantitative easing is being hotly debated. In favor are the president of the European Central Bank and the struggling Mediterranean and Francophone economies; Germany, who would end up paying most of the cost, is opposed. With even the German economy slowing down there’s a strong possibility of renewed debt issues on the continent – but now there’s another issue that could be even worse.
Right now the world’s economic miracle is China. From a mostly agricultural society in the 1960s it’s grown to be a top-rank manufacturer and is steadily diversifying from high volume cheap goods into higher quality products. Growth has been explosive, but now it’s slowing down. And that has implications for the huge industrial sector’s ability to repay its loans.
The scale of loans to growing Chinese companies is immense and rising rapidly; the Swiss-based Bank for International Settlements, the global lending watchdog, says dollar-denominated credit is rising at 47 percent per year. What’s really worrying analysts is that much of the lending in China is camouflaged as inter-department financing within companies. This has been done before, in 1920s Germany, and the reason then was to disguise the state of their balance sheets as the 1929 crash approached. The concern is that a lot of Chinese firms are much more exposed than they’re letting on, and if an economy that size starts to unravel the impact on global markets will be catastrophic.
Now, on top of these worries, the Federal Reserve is starting to tighten up the easy credit that’s been fueling the US recovery. With this year’s growth and jobs figures looking pretty healthy the Fed is winding down its quantitative easing program, and while it’s justified in domestic terms it runs the risk of a credit shock abroad. China and the other East Asian economies are most at risk there but there are also immense dollar loans to other emerging economies – Brazil and Mexico have borrowed eleven-figure sums and Russia’s debts exceed $700 billion. In total cross-border lending in dollars has tripled since 2005 with the full figure now estimated at $9 trillion, mostly outside the US regulatory sphere.
What’s worrying observers is that for the bulk of this debt there’s no lender of last resort. China’s central bank could manage a bailout – it has huge reserves of greenbacks – but the other borrowers probably couldn’t. A crash in any one of them could start a chain reaction through the whole offshore dollar market.
Fund managers are talking up their prospects right now, but the markets are volatile. The BIS believes there’s an underestimated level of fragility beneath the optimistic picture and many of the conditions for a new crisis are already in place. Leveraged loans exceed what they were before the crash at an unprecedented 55 percent of all collateralized debt obligations. Meanwhile the dollar is rising strongly against most other major currencies.
If there are dangers hidden in the current situation there are opportunities too. Commodities are at a bargain price right now but will probably rise in the event of a slowdown. It’s definitely a good time to be making plans for a potential crisis.