Why China's Debt Matters to U.S. Investors

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Trade with China has been in the news recently. But Stephen Ellis, a strategist here at Morningstar, thinks that investors should also pay attention to Chinese debt.

Stephen, thanks for joining me.

Stephen Ellis: Thank you for having me.

Glaser: Thinking about debt in China, why is this a topic that's important to an investor here in the United States?

Ellis: The big picture is that the Chinese credit to GDP ratio had been increasingly significantly over the past couple of years. We found that when that ratio increases very significantly in a short period of time--and China had increased faster than just about any other country in history--that it really raises the prospect of a financial crisis or a sharp slowdown, a sharp and sustained slowdown, in GDP growth.

Glaser: Where is this debt coming from? Is it the government borrowing? Is it households? Is it corporations? What's the mix there?

Ellis: This is primarily, right now, nonfinancial corporate debt and this is primarily from state-owned enterprises which have generally been less productive. Banks have generally lent to them, and they haven't been able to necessarily turnaround and invest that credit in a productive fashion.

Glaser: You see this debt growing. How does that compare to--you said it was the fastest we've seen--how does it compare to other credit crisis that we've seen elsewhere in the world?

Ellis: China's credit to GDP increase has been significantly faster than just about any other country we have seen--Korea, Chile, Brazil have been very, very rapid. All of those countries when the credit bubble has popped, if you will, have seen a 50% decline in real GDP growth. For China, that could be a similar outcome.

Glaser: When you think of those potential outcomes, we kind of talk about the cataclysmic one; is there kind of a muddle-through option as well? How would you think about that?

Ellis: I think there are two major outcomes, and I think really, you're going to see either financial crisis, where you are going to see banks have to recognize no losses have built up over time, and that kind of slowdown could be very disruptive to the Chinese economy. I think the second outcome is, you have a lower for longer scenario where Chinese debt continuing to see cash rolled over by Beijing and by the government and you end up with a lower for longer scenario where basically the growth rate can be very, very slow for a very long period of time.

Glaser: What would be some potential catalysts for this to become a major problem? How long can they continue just adding debt without seeing any of the consequence?

Ellis: I think the main thing that I would be looking would be the real estate market as well as silo banking. The real estate market, I think has experienced a massive boom since the early 2000s. This is primarily in what they are called Tier 1 cities, which are some of the largest and most important cities in China such as Beijing and Shenzhen. What we've found is we've found that essentially those cities have seen basically very, very low supply adding since 2010, while prices have nearly doubled over the last the same time frame.

In contrast, if we look at smaller cities, what they are called Tier 2 and Tier 3 cities, these are significantly sized, but different bucket, if you will, where we are seeing significantly more supply and lower levels of household price growth. To me that is an area where you have the Chinese household growth will get anywhere from 50%, 60%, 70% of household growth tied to the real estate market with the lack of alternatives. If that is an area that potentially slows down or ends up being disrupted by for whatever number of reasons, that would certainly be a catalyst.

Second reason would be silo banking. Silo banking is primarily unregulated financial instruments that have been introduced because of the, again, lack of true market alternatives. This is pretty substantial, $35 trillion to $40 trillion market, that is primarily unregulated products. Again, crack down on regulation and some sort of potentially slowdown in growth or other types of defaults could potentially introduce more risk into the system as well.

Glaser: Stephen, thank you for joining me today.

Ellis: Thank you for having me.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.