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China looks 'a lot like the U.S. in 2008'

Joanna Campione

Sure, China's growth isn't what it used to be, but is the country on the brink of a financial crisis?

Not if you ask its leaders. Vice Premier Zhang Gaoli speaking at the China Development Forum in Beijing on Sunday said China's economic slowdown is stabilizing. Zhang pointed to "employment, services, high-tech industries, new industries, private investment and innovations," as bright spots in China’s economy.

But earlier this month, China set its 2015 GDP growth target at around 7% which is the lowest in 11 years and down from 7.4% in 2014. The economy is being weighed down by a slowdown in real estate and overcapacity at its factories as well as growing local debt.  

China's central bank has cut interest rates twice since last November and freed its banks to lend more over the past few months. 

The Chinese government is also expected to see its largest budget deficit since the global financial crisis this year. In the spring issue of Democracy Journal, Richard Vague, managing partner at Gabriel Investments, says it’s not the public debt that is so worrisome. He says investors should look closely at ballooning private debt in China.

Vague says private debt is a more important factor than public debt in leading to financial crises and he thinks China is heading in that direction. Vague has studied all 22 financial crises for which there is data. He says they all have two things in common: a rapid run-up in private debt and an already high level of private debt to begin with.

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In the video above, Vague tells Yahoo Finance, “When you look at financial crises across the past half century or more, they’re always caused by a runaway—a very rapid increase-- in private debt.” Vague says “that was certainly the case in our ’08 crisis. It was true in Japan in ’91, Asia in ’97. Frankly, it was even true in the United States in 1929."

Vague, who is also the author of The Next Economic Disaster, says right now China has the “largest runaway private debt growth” in world history. “Private debt since ’08 has grown over $12 trillion while [China's] economy has only grown about $4.5 trillion,” he says. “There is a lot of bad debt in the system and way too much capacity.” That capacity includes housing but also raw materials like steel, iron, aluminum and copper. Vague calls it “a massive situation.”

Vague says the important figure to consider is private debt relative to GDP.  In China, that ratio "looks to be about 211% of GDP and that compares to 146% in the United States," he says.  "When we examine financial crises, if private debt grows faster than GDP, which it has in a huge way in China, we estimate roughly a half to a quarter of those loans end up being troubled loans at least to some degree."

Typically a financial crisis is defined by banks failing. Vague points out in China, "Almost different from anybody else who has gone through this in recent pasts, the government owns the banks. So it’s reasonable to believe the government will prop up the banks and potentially the other what are called shadow lenders..." he says. 

"They have ample capacity to do that so that aspect of the crisis is one they very well may avoid," Vague points out.

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