Almost everyone is familiar with Asia’s rags to riches story. The recent economic miracle led to huge increases in living standards across the region. Average incomes rose by factors of 100% to even 400% in some areas. Not to mention the number of people surviving on less than $2 USD a day was cut in half.
A major turning point for this economic wonder was when China joined of the World Trade Organization in 2002. Shortly after, Asia’s contribution to the global GDP jumped from 11% to 21%. However, debt distorts these figures in a variety of ways.
So, that begs the question; was it a miracle or just an illusion? What tricks does Asia have up its sleeve?
Catching up with the rest of the world: one step forward, two steps back
Many are becoming increasingly anxious over Asia’s debt-fueled economy. Their fears may soon become a reality.
Credit-funded economic development may seem like a new concept. But we can actually draw some insightful parallels between present-day China and the nation during the 18th-19th centuries. This was an era characterized by Chinese opium addiction.
If you’ve ever watched a movie set in 18th century England, you may remember how often tea and porcelain were displayed or mentioned. Both were Chinese products in high demand at the time. From trading these commodities, China got access to precious English assets, like gold and silver. Trade channels were established.
Now let’s switch over to another movie: Pirates of the Caribbean. Does the East India Trading Company ring a bell? Due to diminishing English reserves, this private enterprise looked for a solution. They found opium. In the early 18th century, Chinese opium imports was around 200 chests per annum. But by 1859, annual imports had exploded, reaching 70,000 chests per annum.
Their trick worked. Opiate intake rose with greater access. And like most addicts, Chinese opiate users spent their funds to feed their addiction. In turn, silver and gold made its way back to England. It should be noted that the opium era was a destructive time for China. Economic and social development suffered greatly.
Current Asian economies have a new addiction: debt
Just like injecting opium into the bloodstream, injecting debt into a credit-starved, developing economy has a quick effect.
Initial introductions of debt into an economy can produce pleasant returns. For that reason, governments tend to direct debt into the economy into underperforming sectors. Yet, gradually, earnings from debt lessen.
When an entire economy is not meetings its mark, the nation runs into trouble. The unproductive corporate entities, who received their original boosts from debt, start falling like dominoes. They cannot stand up without credit.
Asia’s ability to consume credit seems never ending. Even during the recent financial crisis, Asia witnessed governments working hard to maintain cheap money flowing into their financial systems. The Chinese government implemented a stimulus package with record low interest rates. They wanted to mimic the methods used by other global central banks during the 2007 and 2008 financial crisis.
Despite the large amount of media attention China’s borrowing levels received, they’re not special. As you can see in the chart below, credit levels have soared throughout Asia. Singapore, Hong Kong, Thailand, and Malaysia all have increased their debt to GDP ratios since 2001.
An increased dependency on cheap, available credit produced household debt to shoot up in South Korea and Taiwan.
What are the possible outcomes? In many of these economies, high debt levels could lead to tragedy. The main culprit would be GDP growth rate’s inability to balance out spiraling debt levels.
This situation is called the marginal productivity of debt. Or put more simply, new debt is not as efficient at creating new growth.
Look at the chart below to see how the marginal productivity of debt plays out in Asian economies. Even major, regional growth contributors like South Korea, Japan and China, have experienced this downward trend. Indonesia is the only exception.
Since 2001 China’s marginal productivity has declined by a factor just short of 50%. Since investment has been one of China’s main growth drivers (almost entirely financed by debt), this is concerning.
To add fuel to the fire, much of that debt has been funneled into China’s state-owned enterprises (SOEs). For instance, while corporate debt was at 165% of the GDP in 2015, SOEs made up 71% of it. Meanwhile, those SOEs only contributed around 20% to China’s total GDP.
As you can see from the 2015 figures below, China has allocated an enormous 47% of its debt to SOEs.
So, is debt just a damaging drug? Or is it a helpful medicine that’s being administered incorrectly?
Maybe the problem is how feeble capital is knowingly put into bloated, unproductive SOE’s and inefficient local governments.
The opium den photo below showcases China’s past.
But, what if the modern-day opium den equivalents are the ghost cities popping up in China? They lie dormant, like passed out, unused bodies, all over mainland China.
The photo above is of the Meixi Lake Development in China. With an expected 180,000 inhabitants, it’s definitely one of the world’s biggest urban design projects.
China has made urbanization its mission. In the last three decades, the nation has made enormous efforts to move nearly 250 million citizens (six times the population of California) from rural areas into freshly-constructed cities. Their goal date is 2026.
Yet, many people have yet to make the move. Most of these cities are ghost towns. Without inhabitants, sufficient returns for investors and owners become less likely. Additionally, many of these projected were financed directly by debt and built by SOEs. Only time will tell if they will pay off. Tick, tock.
Projects like these ghost developments highlight why the marginal productivity of debt is quickly plunging in China.
Japan is also wrestling to maintain debt productivity, but for a different reason. Instead of a soaring debt burden, Japan’s issue is its inability to carry-out sustained GDP growth.
It doesn’t look like Asian debt-addicted nations are rushing off to rehab. But with continued declining marginal productivity of debt levels, the double-digit growth rates recently reached by Asian nations will be unachievable a second time.
Indulgence and dependency on debt is a messy affair. Yet, it also creates a window of opportunity for handsome returns in particular sectors.
Knowledge about the marginal productivity of debt will lead you to positive investment decisions.
Company balance sheets will help you find investment opportunities created from debt addiction. You can see which companies are growing from increased debt exposure. Calculate this in relation to total barrowing levels, and you’ll have your answer. Corporations whose profits are surviving off debt, or even whose profits are being chipped away at, will reveal themselves.
Japan is a global economic powerhouse, no doubt. But did you know it was once positioned to overtake the U.S. and become the next superpower? It failed due to detrimental debt and a balance sheet recession. That will be the topic of tomorrow’s daily; the financial consequences from putting all your eggs in one debt basket.