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The two “generic” arguments presented in the earlier entries do not require any specific knowledge about China.  The first argument is that every rapidly growing country runs into periods of financial instability, and China will be no different.  The second argument is that any financial system that enjoys a long period of financial stability and excess liquidity is highly likely to build up imbalances that will require some adjustment. 

China's reserves increased by $117 billion in 2003, $207 billion in 2004, $209 billion in 2005, $247 billion in 2006, and $266 billion just in the first half of 2007.  Each dollar of reserve growth is matched by an increase in currency and central bank bills in circulation.  China's money base has been growing at a rapid and accelerating pace.  China has had too much liqudity for too long, and and with its rigid and opaque financial system, the adjustment is probably inevitable and likely to be painful.

These “generic” reasons as to why we should be concerned are, to me, pretty compelling.  China is undergoing conditions – rapid economic growth under conditions of explosive growth in liquidity and credit, low or negative real interest rates, and significant policy intervention – that have almost always led, in other cases, to financial imbalances, and it would be strange to assume that they would not in this case. 

It is not necessarily the case, however, that an adjustment need be violent.  This depends on the structure of the financial system and the national balance sheet. If balance sheets are strong, the adjustment can be localized; if the financial system is healthy and flexible, the transmission into the real economy can be minimized; and if government debt levels are low, financial authorities can counteract the impact of the adjustment.

But there are very China-specific reasons that give cause for worry.  Financial crises occur when a country, whose balance sheet includes a lot of unstable, or badly structured, debt, is affected by an adverse shock that sets into motion a collapse in the balance sheet.  An economic crisis follows only if and when the financial crisis is transmitted into the real economy – almost always by shutting off the ability of producers and/or consumers to finance their activity.

What are the conditions for balance sheet instability?  In my book (The Volatility Machine) I list three.  There must be high levels of debt.  The relationship between assets/operations and debt/debt financing must be “inverted”.  And there must be self-reinforcing, sometimes referred to as pro-cyclical, mechanisms imbedded in the balance sheet.

What is a high level of debt?  There is actually an easy way to answer what seems like an impossibly difficult question: a high level of debt is whatever the market considers at any given time to be too much debt.

This answer is not a cop-out.  When the market believes that debt levels are too high it responds by forcing the yield to rise, and it is precisely high yields that are the problem.  They are a problem not because (or not mainly because) the government must now pay a lot more for new borrowings, so jacking up the fiscal deficit.  They are a problem because exisiting debt changes the incentive structure for old and new investors.

The higher the real yield on exisiting debt (the lower its price) the greater the share of the benefits of new investment that accrues to old lenders, and the smaller the share that accrues to new investors.  This is because improvements in the country's repayment prospects are shared between the exisiting creditors and new investors. 

This doesn't matter when repayment prospects are very high, since the share of the improvement that goes to existing creditors is very small (they are already highly likely to get repaid).  But it matters a lot when the market thinks repayment risks are very high (i.e. the real yield is very high).  For option geeks the relative share of any change in asset values that debtors and equity investors receive is referred to as delta.

The higher the delta for debt, the lower for equity, since delta must always add to one (i.e. 100% of the change in asset value must go to debt and equity investors), and by definition the smaller the share equity investors get of any change in asset value.  This creates a disincentive to invest and an incentive to disinvest (as any banker who deals with debt restructuring knows).  When investors believe a country has too much debt they force changes in the value of debt (increase yields) that automatically causes reduced investment or even disinvestment, and this has an obvious adverse impact on the ability to pay.  This is one reason debt crises often seem to spiral out of control.

Is China at risk of having too much debt?  We don’t really know, but a very plausible case can be made that it is.  I have written elsewhere about my estimates for the government’s total debt levels – officially around 30% of GDP but probably over 60% of GDP when you include contingent liabilities arising from unrecorded provincial and municipal debt and non-performing loans in the banking system. It is not hard to make a case that in case of an unexpected economic or liquidity contraction, non-performing loans will shoot up and force attention onto the country’s real debt levels, and the market might judge these levels to be too high.