A New Measure of China's Vulnerability
Where in the world might the next financial crisis start? If you believe a new measure of credit risk, China is the leading candidate.
The 2008 financial crisis helped bring global leaders to the realization that they needed a better early-warning system. To that end, the Bank for International Settlements -- a sort of central bankers' central bank -- has been publishing more data on money flows around the world. These include an indicator called the credit-to-GDP gap, which focuses on the amount of credit being provided to households and businesses as a share of gross domestic product. The more the indicator rises above its longer-term trend in a given country, the more likely it is that borrowers are getting overextended -- a situation that tends to lead to defaults, banking troubles and broader slumps.
In hindsight, the measure would have done a pretty good job of indicating trouble ahead of the most recent crises in the U.S. and Europe. U.S. credit peaked at about 12 percentage points above its long-term average in mid-2007, just as the subprime-mortgage boom turned to bust. The average gap in Greece, Italy, Portugal and Spain reached a high of 34 percentage points in early 2009, ahead of the European sovereign-debt disaster. Here's how that looks:
Now, the indicators for the U.S. and Europe are in negative territory -- a reflection of struggles to restore growth while still working through the excesses of the previous boom. The credit gap in China, by contrast, is at its highest level since at least 1995 (the first year of the data series): As of March, it stood at more than 30 percentage points. Here's a comparison with other G-20 countries:
To be sure, China is an unusual case, with vast holdings of foreign reserves and a level of government control that could allow it to postpone a reckoning or spread the pain over many years. Even in the southern European countries, the gap remained high for almost a decade before anything bad happened. Still, when a country becomes so dependent on credit to drive growth, something usually gives.
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