Chinese Debt Crisis in the Making?

With the world’s largest economy facing a potential slowdown because of sequestration, it’s not exactly comforting to find out that the next largest nation might be in trouble as well. How bad is it in China?

Just last week, the HSBC and official manufacturing PMI figures for February came in below expectations and lower than the January readings. The HSBC final manufacturing PMI fell from 52.3 to 50.4 while the official manufacturing PMI slipped from 50.4 to 50.1 instead of rising to 50.5 as expected. Although both figures are still above the 50.0 level indicating industry expansion, the latest readings are sitting dangerously close to the contractionary zone.

These bleak manufacturing reports are just the tip of the iceberg. A closer look at Chinese economic data hints at a debt crisis in the making. So far, the debt drama of Europe and the U.S. are hogging the spotlight, casting a shadow on the looming financial mess in the other side of the globe.

According to an emerging markets head analyst in Morgan Stanley, Ruchir Sharma, China’s total private and public debt has ballooned to more than 200% of its GDP over the past four years. He pointed out that this rate of increase in debt, particularly in the private sector, is unprecedented for any developing country.

Let’s zoom in on China’s private debt. The Bank of International Settlements (BIS) published that a country’s private debt with an acceleration rate of 6% higher than its 10-year trend should be seen as a financial red flag. China private debt rate is currently 12% higher than its decade-long trend, which is faster than the rates seen before the credit crises in the U.S. (2007), Japan (1989), and Spain (2008).

Even the International Monetary Fund (IMF) is shaking its head. It discovered that a country with private debt that’s growing faster than its economy for three to five years should also be closely watched. But China’s private debt growth has been exceeding its GDP growth since 2008! Also, China’s private debt to GDP ratio is now at 180%, which is what the U.S. and Japan sported right before their financial crises. Talk about déjà vu!

With the U.S., Japan, and the euro zone already in hot water, it won’t do the world economy any good if it also has to worry about the second largest economy. We could see a return to risk aversion, especially if China shows more signs of an imminent financial crisis.

And that’s just in the near future. The IMF estimates that if China’s investment growth drops by just one percentage point, it could cost regional supply chain economies like Korea, Malaysia, and Taiwan as much as 0.5% to 0.9% of their GDP. It could then trickle to manufacturing economies like Germany and Japan, and even hit commodity-producing countries.

Does this mean that you should sell all your commodity and Chinese-related assets like hot potato? Heck no! This just means that you should choose your next investments wisely and be mindful of the potential impact of a slowdown in the Chinese economy.