What’s the balance sheet recession some claim it’s going on in China?
A balance sheet recession is a toxic economic loop where after being burnt by deleveraging and lower asset prices households and corporates refuses to take in new credit and focus on just repaying their debt and shrinking balance sheets.
That causes a vicious loop of further deleveraging, lower asset prices and lower economic activity which can’t be stopped with lower interest rates.
Let’s first quickly cover how our credit-based system works in normal times.
The top part of this chart shows what happens then:
1) The private sector likes (particularly if cheap) leverage and so lending activity is robust;
2) Banks make new loan/credit, hence new real-economy money is created;
3) That pushes economic growth and asset prices higher.
But what happens during balance sheet recessions (bottom part of the chart) instead?
– After Xi’s clampdown house prices started to drop hence hitting the capital position of highly leveraged Chinese households
– No softening of this stance and continued weakness in the housing market led developers and households to a rush to stay solvent: pay back your loans/mortgages as fast as you can – deleveraging in motion!
– Lack of new credit plus actual deleveraging hits house prices further in a vicious loop also known as…balance sheet recession!
How do you structurally fix a balance sheet recession, and is China moving in the right direction?
For sure you can’t fix it by lowering interest rates and Japan shows us why.
In the early 1990s the Japanese real estate bubble burst and the world’s most famous balance sheet recession unfolded – the BoJ lowered and kept rates to 0% for decades after and…nothing happened.
When you hit corporates and consumers’ balance sheets hard through a deleveraging process, asking them to take on…more credit isn’t going to work even if interest rates are low.
The PBoC can cut rates further but that’s not going to do much.
The best chance to stop a balance sheet recession is through targeted fiscal stimulus.
Exactly like the US did in 2009 and in a stealth way ever since the Chinese government can step in and use its balance sheet to throw fresh resources at troubled real estate developers and households.
It’s basically akin to a capital injection which stops the bleeding and allows the private sector to repair their balance sheets over time.
The problem is that China isn’t doing fiscal, or even seriously considering it so far.
So, what now?
