Michael Pettis on Debt in China

The problem, as I see it, is that the system has reached the point at which unsustainable increases in debt are necessary to sustain growth.

When is an increase in debt unsustainable?

As I see it there are three things that make increases in debt unsustainable. The first, obviously, is borrowing for consumption. This is what happened in the US and in the peripheral countries of Europe until the 2007-08 crisis, and it is pretty clear that this kind of borrowing cannot go on forever. Why not? Simply because with consumer financing the value of liabilities rises more quickly than the value of assets, and this cannot go on forever unless the borrower has an infinite amount of excess assets….

The second way we can experience an unsustainable increase in debt is when borrowing is used to fund investment that is misallocated or wasted. Whenever the value of liabilities rises more quickly than the value of assets, the increase in debt is by definition unsustainable unless, of course, the borrower has an unlimited amount of excess assets….

The third kind of unsustainable debt increase is caused by a sudden explosion in contingent liabilities. When balance sheets are structured in risky or mismatched ways, an unexpected change in circumstances can cause a sharp change in the relationship between the values of assets and liabilities, and so result in a net surge in indebtedness….

It is important to remember this when thinking about financing risks in China. We often hear analysts argue that because China has little consumer financing and because mortgage margins are high, they don’t have a debt problem. This argument is about as useless as the claim that because China has large reserves it is unlikely to have a financial problem. The limited consumer and mortgage financing in China means that china will not have a US-style financing problem, and the large amount of reserves means that China won’t have a Korean-style financing problem, but no one has ever seriously argued that those are the kinds of risks China faces. What matters is the level of debt, whether or not its growth is sustainable, and the kinds of contingent structures that are embedded. I would argue that all three measures are worrying.

Pettis provides the rationale and data in Incentives and debt