Is the Chinese Economy a Ponzi Scheme?

November 20, 2015 Updated: December 10, 2015

China watchers have long waited for this moment to happen: the moment when the debt bubble finally blows up.

We haven’t seen the explosion yet, but we are getting closer, according to a recent report by Hua Chuang Securities cited by Bloomberg.

The shocking finding: Chinese companies are using as much as 45 percent of new debt issuance just to pay the interest on existing debt. To the tune of $1.2 trillion this year.

“One of the reasons credit is growing is because they are using loans to pay interest payments. The primary need and use for expanded private credit is to fund the interest payments,” says Richard Vague, author of “The Next Economic Disaster.”

(Source: Bloomberg)
(Source: Bloomberg)

This is called “Ponzi finance,” named after Italian-American Charles Ponzi. He set up a scheme of importing cheap postage stamps from Italy and selling them at a higher value in the United States.

He borrowed money from investors for the scheme and paid old investors with money from new investors. Bernie Madoff is a more recent example.

Here’s the problem with these Ponzi schemes: They don’t work, as the underlying investment isn’t productive and doesn’t generate any return.

Normally, companies take out loans to invest in productive assets or research or staffing which then generates a return to pay back the interest and the loan.

Borrowing money to pay back interest from previous loans doesn’t fit this “productivity criterion” and is usually a last resort before bankruptcy.

Chinese companies have borrowed heavily in the past and apparently did not use the funds wisely. Otherwise, they would be able to make their interest payments without raising new money.

Macquarie recently found out that more than 20 percent of the companies it analyzed cannot cover their interest expenses with just their income from normal operations.

The total level of corporate debt including bank loans and bonds, as well as shadow financing, is about 125 percent of GDP at $10 trillion, according to McKinsey.

Source: McKinsey
Source: McKinsey

“If you go back to the Beijing Olympics in 2008, China was this miracle growth economy. Two Olympics later China is a debt story, no longer a growth story,” says Fraser Howie, author of “Red Capitalism.”

When banks cut off this last resort of Ponzi financing, the company follows the same fate as Charles Ponzi or Bernie Madoff: default.

Only three years ago the term “default” was unheard of in China, but this year already six companies could not meet their payments. 

“When I was in China in the late ’90s underwriting bonds, people just assumed there is no default risk, the government will bail you out,” says Howie.

“Will they allow defaults? This is critical to see whether they allow the market to function,” says Diana Choyleva, chief economist at Lombard Street Research.

Given the huge amount of Ponzi financing, the answer is probably no, at least not for the time being.

“One of the dangers when you’ve got a credit boom like that going is you’re terrified of keeping it going. If you keep it going for longer, you’re going to have a worse problem when you eventually stop,” says Adair Turner, the former British Financial Services Authority chief and author of “Between Debt and the Devil.”

“But you’re terrified of stopping it because the moment you stop it, you’re going to have a whole load of unemployed builders and steel mills with excess capacity.”