China took over from the West after the great financial crisis of 2008, adopting a growth model based on the expansion of debt. That policy helped support the global economy and somewhat mitigated the great recession in advanced economies, but as always happens, excessive debt eventually takes its toll. They were years of excessive credit facilities that caused enormous investment in sectors sensitive to interest rates, such as real estate. In addition, local authorities also took on excessive debt, often opaquely.
The consequences of Covid have prevented us from clearly perceiving what was happening, but the bursting of the bubble has already been underway for some time. The problems of large real estate companies began in 2021, with the bankruptcy of Evergrande, and continue. The crisis is also affecting important, poorly regulated financial intermediaries. What could be the repercussions for the rest of the world of the bursting of the Chinese bubble? The main one will come through foreign trade, since China will grow less in the coming years. As we learned in developed countries 15 years ago, the digestion of a debt bubble is heavy. It causes very weak demand, deflationary pressure and prolonged contraction of sectors that grew excessively.
Digestion can be very slow if the cleanliness of the balance is not well managed. The difficult thing is to recognize that many debts are not going to be paid and that, therefore, some creditors are going to suffer significant losses. In China, the authorities play a decisive role and it is possible that the restructuring of debts and the recapitalization of companies that are still viable can be done quickly and thus avoid a long period of poor growth. This is what happened in the US after the financial crisis, although there it was due to the rapid reaction of the public sector and the flexibility of the legal system, and not because the government had exceptional powers.
China also has a reasonably healthy public sector. The government could, therefore, inject resources into the economy to facilitate the digestion of the bubble and do so on a discretionary basis to prevent the survival of insolvent entities or zombie companies.
If the coffers of the Chinese state are emptier than we think, the situation will be more complex. The country could dip into its savings invested in the North American bond market, with negative consequences for the dollar and interest rates in the US. Or it could resort again to monetary expansion and a probable devaluation of the currency to resume the path of growth through the traditional route of the foreign sector, an alternative not without problems today. Debt bubbles, when they burst, are rarely easy to digest. The magnitude of the Chinese bubble could even exceed the capacity of its economy to absorb it.
