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Is the Chinese self-destruction unavoidable? - Views on News from Equitymaster
 
 
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  • Jul 5, 2013

    Is the Chinese self-destruction unavoidable?

    Barely a day goes by these days without a mention of China and the possibility of the country witnessing a strong meltdown. The fact that data coming out of dragon nation is not entirely trustworthy is adding further fuel to the fire. Indeed, the country has been some sort of an economic black box. It is growing alright but so are the concerns with respect to the sustainability of its economic miracle.

    Recently, we came across an article which talks about the high probability of China witnessing its own Minsky Moment anytime now. A term coined in reference to the famous economist Hyman Minsky. As a matter of fact, there seems to be some sort of revival of the teachings of Minsky in these recent times.

    For the uninitiated, Minsky's claim to fame is a theoretical framework that he felt explained how financial crises occur. As per him, the accumulation of debt is what leads an economy to a crisis.

    He argues that when the going is good, companies raise debt which then helps them to earn more profits. Thus, the more debt a company piles on, the more profit it earns. Now, in a capitalistic economy, competition is omnipresent. Thus, if a few companies are seen raking in profits, others too join in the act. They perform a similar exercise of raising debt and bring in profits.

    However, nothing goes on forever. Thus, eventually there comes a time when the pace of debt accumulation becomes faster than the rate at which profits can come in. And when that happens, it is safe to assume that the wheels of an economic bust are set in motion.

    Minsky hasn't stopped at this. He has simplified his theory further by defining three types of borrowers. The first one, known as the hedge borrower, is able to meet all his debt payments from his cash flows. Then comes the speculative borrower who while does not earn enough to repay the debt, is at least able to come good on his interest payments. As for the debt, he keeps rolling it over.

    And then there is the third and final category of borrowers called as the Ponzi borrowers. The name itself suggests that all Ponzi borrowers seem capable of doing is bring in new debt to pay out the old. These people can neither repay the debt nor the interest and thus depend only on the appreciation of their asset values for refinancing of their debt.

    Thus, as time goes by an economy has less of hedge borrowers and more of Ponzi borrowers and this in turn pushes enormous strain on the economy and makes it extremely fragile. Finally, the end game begins where lenders find it too risky to lend to borrowers especially the Ponzi ones who are then forced to liquidate their assets or declare themselves bankrupt.

    We must say Minsky's framework does do a good job of describing the events leading up to a financial crisis. And while we don't have a great understanding of how the Chinese economy functions, we do know that the debt productivity of the country is on a declining path. In other words, it is taking in more and more debt to create a unit of GDP. Thus, in Minsky's language, the situation seems to be somewhere between a speculative borrower and a Ponzi borrower. Now, the question is will the Chinese policymakers be able to prevent any further damage? Sadly, the stories doing the rounds do not seem to be giving any signals along those lines.

    In fact, Kyle Bass, a well known hedge funder has even gone to the extent of saying that the country could see a full scale recession and property bubble collapse as early as next year.

    Of course, we can't be as sure as Mr Bass is. But what we will certainly vouch for is the usefulness of the Minsky framework. As a matter of fact, it further reinforces our belief into buying into stocks with strong balance sheets and resisting the temptation of investing in Ponzi borrowers no matter how attractive the valuations or even speculative borrowers if possible.

     

     

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