The epic meltdown in financial markets that occurred in 2008 was a painful reminder that even developed economies in this day and age cannot avert financial crises.
Most academics and central bankers also claim that these crises cannot be predicted with any accuracy. More innovative researchers, like Richard Vague, beg to differ. In his book, “The Next Economic Disaster,” he outlines an approach to predict financial crises with a high degree of accuracy by focusing on private debt.
Richard Vague (Courtesy of Richard Vague)
In his opinion, a sustained rise of private debt, like mortgages or corporate bonds, over five years almost inevitably leads to a banking or currency crisis. As for where the next disaster looms, Vague is looking east.
Do you have a special focus on China?
I don’t have a special expertise in China. However in the process of pulling together private debt information I think I have a very good understanding of private debt in all major countries including China. These findings have given us a good understanding of private debt in China.
What happened to the debt levels in China in the last five years?
Whenever we have seen very rapid increases in private debt in any other country—that includes the United States in 2007, Japan in 1991, South Korea in 1997—we have seen an ensuing financial crisis or at the very least a dramatic slow-down in GDP.
Whenever we see private debt as a percentage of GDP grow by 18 percent over a five-year span [that is, from 100 percent of GDP to 118 percent of GDP] and we also see aggregate private debt to GDP at a 150 percent or greater; the combination of those two things almost always means that you have a financial crisis.
So what are the stats for private debt in China?
In China it looks like it has grown 60 percent over the past five years to 200 percent, well in excess of the threshold. You saw that in Spain in 2008, its private debt to GDP grew by 49 percent in the five years prior to the crisis and we can see what Spain is suffering today.
So the more private debt increases, the more you suffer afterward?
That’s right. However, what we have seen is that it can go on for several years. It is not unusual that it will continue for another few years once you hit that high growth level. The party can keep going as long as the banks continue to lend.
When can you see the tipping point?
When overcapacity is so significant, the banks have to start dealing with it. Markets then start recognizing that asset values are too high. Then you start to see things reverse. But we are not fully there yet today in China.
But it feels like something is going to happen in the next two or three years. But the Chinese [regime] can go in and pre-emptively deal with the situation. They might be doing this behind the scene for all we know. They can go into the banks and inject capital and allow those banks to be fortified against the problem.
However, they still have built too much capacity. Even if the central government fortifies the banks China has too many houses, too much steel, too many ships.
Where does the capital come from?
It could be from the central government’s assets or central government debt. China has ample resources to deal with this at the central government level. Central government debt is low compared to other major economies.
That’s what happened in Japan in 1991. Government debt to GDP was 60 percent. Now it’s 220 percent because of reduced tax revenues after the crisis, and the efforts to offset the economic impact of the crisis.
What will be the consequences of this operation?
If China is growing at 7.5 percent, it is adding more capacity to what is already too much capacity. So we can’t predict what will happen to GDP but we won’t be surprised if it will be in the low single digits over the next few years.
At the very least, China’s GDP growth is going to have to slow down considerably. We could see real GDP growth below 5 or 4 percent. I think you are looking at a generation of slow growth, just like you did in Japan. The problem hit in Japan in 1991 and it has now been 24 years and their real growth has averaged less than 1 percent per year during that time.
We think between the recapitalization of the banks and an expanded social safety net, the cost could be anywhere from 20 to 40 percent of GDP to recapitalize the banks and manage the crisis.
Is there any way to solve the problem quick and painless?
If I had a magic wand in China I would go in and inject a large amount of capital into the banks. I would let those banks then go to overleveraged borrowers and restructure debt with these borrowers so that overall they deal with their bad debt problem before it becomes a crisis.
This means writing down and restructure a lot of debt
That’s exactly right. Another approach would be to use a form of forbearance to let the banks amortize their bad debt over an extended period, 30 years for example. You can let them write down the loans, but you would take that and put it in a suspense account so it doesn’t hit equity right away, rather very slowly over a longer period of time.
What about printing money?
You can do that. It’s not my favorite solution. But money is just debt without a maturity or coupon on it, so it’s kind of the same thing in some respects.
Richard Vague is managing partner at Gabriel Investments and the chairman of The Governor’s Woods Foundation, a nonprofit philanthropic organization. He is also the author of “The Next Economic Disaster,” a book with a new approach for predicting and preventing financial crises. Previously, he was co-founder, chairman and CEO of Energy Plus, and also co-founder and CEO of two consumer banks, First USA and Juniper Financial.
The interview has been edited for brevity and clarity.
