The Great Wall of Debt

What effect does China’s debt have on its economy?

Photo: Severin Stadler. Source: Wikipedia

The Great Wall of China was built over the course of several centuries to protect the Chinese Empire from invasion by mostly northern nomadic tribes. It stretches about 1,500 miles, although with all the extensions and branches, there are over 20,000 miles of fortifications. In the short run, the Great Wall served to discourage raiders and helped rulers manage trade. In the long run, however, it became economically unsustainable—absorbing labor and resources that were better used elsewhere.

Is China’s debt serving the same function? During the financial crisis China responded with a massive amount of borrowing—over $500 billion, in an economy of only $4 trillion—about 12% of the economy. This kept their economy growing, and helped establish China’s position as a major player in global trade. Moreover, since most of this debt has been issued by local governments in local currency, they “owe it to themselves.” China won’t have to send cash back to foreign creditors as they service their debt.

Source: VoxEU

But what are the longer-term effects? It turns out that the massive local borrowing has had a negative effect on the formation of private manufacturing firms. It’s harder for smaller button factories and shoe-makers to get access to capital and workers. Those are being absorbed by the state-owned companies, which have better political connections and more stable credit foundations. In short, the state-owned companies are crowding out the private firms.

But the private firms have much higher levels of productivity. They’re more flexible: able to relocate to better facilities when new highways are completed or new electricity-generating utilities come on-line. They can respond more readily to new market conditions. By supporting state-owned factories during the crisis, China may have reduced its long-run growth—not to mention, saddling its banks with a lot of local government debt, potentially increasing its systemic financial risk.

Government debt is neither a blessing nor a curse. It is financial tool that has to be used wisely. If it ceases to be productive, it may become a legacy asset—a curiosity—like the original Great Wall itself.

Douglas R. Tengdin, CFA

Chief Investment Officer

By | 2017-07-17T12:21:37+00:00 November 8th, 2016|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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