China's "Minsky Moment" Is Here, Morgan Stanley Finds

Tyler Durden's picture

From Morgan Stanley's Cyril Moulle-Berteaux and Sergei Parmenov, who pick up where our simple chart showing China's "debt nightmare" left off.

We have described in detail over the past two years how we believe China’s twin excesses (excessive investment funded by excessive debt) will inevitably unwind, causing a substantial slowdown in China’s economy, significantly below market expectations. In recent weeks, a trip to the region and further research into China’s shadow banking system have convinced us that China is approaching its “Minsky Moment,” (Display 1) which increases the chances of a disorderly unwind of China’s excesses. The efficiency with which credit generates economic activity is already deteriorating, as more investments are made in non-productive projects and more debt is being used to repay old debts.

Based on our analysis, our baseline case is that China may slow from the current level of 7.7% Gross Domestic Product (GDP) growth to 5.0% over the next two years. A disorderly unwind could take Chinese growth down to 4% in a shorter time frame with potentially disastrous consequences for levered Chinese assets (banks, property) and the entire commodity supply chain (commodity stocks, equipment stocks, commodity-sensitive countries and their currencies).

The consensus is more optimistic and expects China’s economy to grow by 7.4% in 2014 and 7.2% in 2015. Most market participants have concluded that the Chinese economy, despite its excesses, will slow only moderately as the government successfully manages to “soft-land” the credit and investment boom and that, as a result, the impact on global GDP growth could be moderate and is not likely to derail the global developed-market-led expansion. However, one of the more controversial conclusions of our analysis is that global economic growth could be impacted severely enough to cause a global earnings recession.


Hyman Minsky was a neo-Keynesian economist who developed a theory called the Financial Instability Hypothesis, similar to the Austrian school of thought, about the impact of credit cycles on the economy. In his 1993 paper entitled “The Financial Instability Hypothesis,” Minsky identified three financing regimes that economies can operate under: the first, which he called hedge finance, is a regime in which borrowers have sufficient cash flows to meet “their contractual obligations,” i.e. interest payments and principal repayment, usually by having a large equity component in their capital structure; the second, speculative finance, is a regime under which borrowers have cash flows that are sufficient to pay interest but not to repay principal, i.e. they must roll over their debts; the third, Ponzi finance, is a regime in which borrowers have insufficient cash flows to pay either principal or interest and therefore must either borrow or sell assets to make interest payments.

Minsky stated that “it can be shown that if hedge financing dominates, then the economy may well be an equilibrium-seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system.” His paper draws the following two conclusions: 1) that “the economy has financing regimes under which it is stable, and financing regimes in which it is unstable” and 2) “that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.” In essence, the longer an economic expansion goes on, the greater the share of speculative and Ponzi finance, and the more unstable the economy becomes.

Our analysis indicates that China’s economy has arrived at that unstable state where speculative and Ponzi finance appear to dominate. From a macroeconomic perspective, very few economies have ever created as much debt as China has in the past five years. China’s private sector debt has increased from 115% of GDP in 2007 to 193% at the end of 2013.3 (Display 2) That 80% increase over five years compares to the U.S.’s 26% in 2000-2005. In recent years, only Spain and Ireland have achieved debt growth greater than China’s. Every year, China is now adding $2.5 trillion of private sector debt to a $9.7 trillion GDP.

There is evidence that this debt growth has become excessive and non-productive. It now takes 4 renminbi (RMB) of debt to create 1 renminbi of GDP growth from a nearly 1:1 ratio in the early and mid-2000s. After the massive stimulus and more than doubling of new bank loans in 2009, the government attempted to stabilize credit growth, but the growth of the shadow banking system exploded instead. Shadow banking now accounts for more than a fifth of total credit in China—or about 40% of GDP from a base of 12% just five years ago. The shadow banking system funnels credit to borrowers who can no longer get loans from the formal banking sector, such as Local Government Funding Vehicles, the property sector, and companies in sectors with massive overcapacity and low or negative profitability such as coal mining, steel, cement, shipbuilding, and solar. Work by Nomura’s Chief China Economist indicates that more than half of Local Government Funding Vehicles, which borrow money on behalf of local governments to invest in infrastructure, have insufficient cash flows to pay interest or principal; the exact manifestation of Minsky’s Ponzi finance regime. Total local government debt adds up to RMB17.9 trillion (nearly $3 trillion) according to the latest, likely understated, national audit. In addition, estimates show that up to one third of all new borrowings are currently being used to roll over existing debt, and that interest payments on debt represent nearly 17% of Chinese GDP—a staggeringly large number (which excludes principal repayments) and which is nearly double the level that the U.S. reached in 2007. (Display 3)

It is clear to us that speculative and Ponzi finance dominate China’s economy at this stage. The question is when and how the system’s current instability resolves itself. The Minsky Moment refers to the moment at which a credit boom driven by speculative and Ponzi borrowers begins to unwind. It is the point at which Ponzi and speculative borrowers are no longer able to roll over their debts or borrow additional capital to make interest payments. Minsky states this usually occurs when monetary authorities, in order to control inflationary impulses in the economy, begin to tighten monetary policy. We would add that this monetary tightening often begins to occur at the time when the size of speculative and Ponzi borrowings have become so large that the demand for additional capital to keep these borrowers afloat becomes greater than the supply of such capital. We believe that China finds itself today at exactly this juncture.

The People’s Bank of China (PBOC) has been slowly tightening credit for nine months. This can be seen in the steady uptrend in interbank financing costs (the one-month Shanghai Interbank Offered Rate, or SHIBOR, is up 220 basis points since last May). The PBOC’s latest Q4 Monetary Policy Report indicates it intends to continue to tighten liquidity in order to control the excessively fast growth of shadow banking credit.

Of the $1.8 trillion in Trust Loans provided by the shadow banking sector, nearly $600bn, or RMB 3.6 trillion will come due in 2014. (Display 4 shows maturities for a sample of half of collective trust loans, which represent one quarter of total trust loans)

Defaults or near-defaults have begun to occur with regularity over the past three months and are likely to pick up in quantity significantly over the next year. As it is becoming more clear that investors may not get all of their money back, interest rates on trust products, wealth management products (WMPs), corporate bonds, and bank loans have risen by roughly 200 basis points in the last year. (Display 5)

So at the same time that large amounts of debt come due and borrowers are increasingly stretched, growth is slowing, monetary policy is being tightened, and market rates are beginning to rise, making new borrowings even more expensive and difficult. The combination of these factors indicates to us that China’s Minsky Moment is approaching.

The unwind of this credit boom is likely in progress, and we expect it to pick up speed over the coming months and quarters. It will likely involve a steady drip of defaults and near-defaults as insolvent borrowers finally become illiquid. Market rates for all assets except central government bonds and central bank bills will likely continue to rise, reflecting increasing market fears of default by shaky borrowers. Asset values will likely begin to deteriorate as stressed borrowers attempt to sell assets to stay afloat. As a result, banks and other financial entities could begin to increase provisioning for bad debts and to reduce credit availability by gradually tightening credit standards. This could lead to a credit crunch where credit to the economy is choked off for all but the safest borrowers.

This rise in defaults, non-performing assets, and credit standards could exacerbate a significant slowdown in economic activity concentrated in the areas most dependent on debt, such as local government infrastructure spending and the sectors with the greatest overcapacity mentioned above.

The impact would therefore be most visible in the fixed investment side of the economy, particularly in infrastructure, real estate construction and related industries (cement, steel, machinery, etc.).

In time, the slowdown in growth and the increase in defaults could become significant enough that the government would intervene and ease policy to moderate the downturn. This policy easing would likely involve a combination of monetary easing and extraordinary liquidity by the PBOC and possibly, some fiscal stimulus. But until then, the impact on assets that are dependent on China’s debt growth and investment spending growth could be severe.

We recognize that it is extremely likely that the Chinese government will attempt to stave off the unwind or at least keep it orderly in an effort to achieve the ever-elusive soft landing. One way that the government could attempt this would be by stepping in to bail out borrowers on the verge of default. A version of this occurred in January, when the well-publicized default of a RMB3 billion China Credit Trust product was averted when an unknown entity stepped in to pay the principal due to investors, though not the remaining interest due (worth approximately 7% of principal). The unknown entity is likely to have been either the local government of Shanxi, home of the coal mining company that defaulted on the underlying trust loan, or the Ping An insurance company, parent of China Credit Trust. The benefit of the government or other entities stepping in to bail out borrowers is that it helps prevent investors from losing money, maintaining their faith in the financial system and ensuring they continue to buy trust products offering rates five times above deposit rates. The drawback is that credit continues to be extended to weak or insolvent borrowers, potentially leading to an even higher level of bad debts in the future. The problem is not eliminated, it is simply postponed. Interestingly, growth is likely to be negatively impacted whether or not the government steps in frequently to prevent borrowers from defaulting. First, scarce capital is being provided to prevent default by insolvent borrowers (“zombies”) rather than being channeled toward productive investments. Second, in order to limit the cumulative size of the bailouts, the government is likely to continue to restrict the growth of shadow banking and lending to these uncreditworthy borrowers. Lastly, market rates are likely to continue to rise, reflecting increasing market unease with the growing number of near-defaults.

Most other analyses we have seen conclude that China could slow more than currently expected by the consensus, but that the global economy is well-positioned to withstand such a slowdown. Our conclusion is a bit more pessimistic. We have found that every 1% of Chinese GDP deceleration could reduce global economic growth by 60 basis points. On a current dollar basis (i.e., not purchasing power parity, or PPP), the global economy is expected to grow about 3% in 2014 and 2015. (Display 6)

Therefore, if the Chinese economy were to slow by 200 basis points to 5.4%, from current expectations of 7.4% for 2014,13 (Display 7) global economic growth would slow to 1.8%, substantially below potential of 2.8%. This could have a significant impact on global equities, as our analysis shows that the global economy needs to grow at least 2.5% for global corporate profits to grow. Thus, a 1.8% pace for global GDP growth would result in earnings down roughly 13%, a huge miss compared to current expectations of 11% earnings growth. At this point, this is not our base case but a risk scenario we are closely monitoring.

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Kirk2NCC1701's picture

Fine.  This seems to suggest that Free-Market forces will actually be allowed to play out in China, which will results in Winners and Losers.

But, ultimately, their system (inflated as it is) will be allowed to self-heal, rather than remain on life-support in ICU.  Imagine that!

If we brush the paper-games aside for a minute, and compare the fundamentals, I still see China as a place where:

> China has a HUGE domestic consumer market, for real and potential

> China has much lower wages than the US.

> China has no real foreign debt.

The US has unvarobale demographics: aging population, that requires ever-increasing health care and elder care.

> Health care and Elder care costs in the US are "out of this world".  It's a total racket (e.g. an arrested Jersey rabi bought a kidney for $10k, sells it for $160k).  NOT sustainable.

> US Education costs are sky-high and also a racket.  University operating costs did not rise nearly as fast.  Their finance guys decided to "invest" the cash on Wall St, and took a beating in 2008/2009.  Upshot?  They decided to increase tuitions, to cover their tracks.  What a racket!

> When US stock and bond markets finally get corrected, so do their leveraged Derivatives markets -- which would crash proportionately faster and harder.  So, the key to keep the Derivatives from going "ballistic", is to "control" the stock markets in the US and EU.  But this can happen only as long as no Black Swan political event swamps their ability to control.

This reminds me of someone trying to convey that "Rome is much better off than those Barbarians outside the City.  We got it all, they are dirty and hungry".  Yeah, sure, keep saying that to the Plebeian Masses, while the Elite and Senators plunder Rome and set up their wealth in a variety of coon-to-come City States all over the Empire. 

History sure does rhyme:  Expect our Elite, Oligarchs and Senators to become Citizens of soon-to-come Neo-Feudal regimes.  Keep stocking, packing, and stacking.  The Barbarians will come, the Deluge will come.

shovelhead's picture

Say what you will about China's precarious situation but at least they won't die a slow death like America with the Ebonic Plague.

Whole cities are succumbing to it's unshakeable death grip.

LFMayor's picture

but... but...   They said diversity was our STRENGTH!

Seer's picture

Inbreeding works really well, just look at the Brits...

Cthonic's picture
Pfff, they got nothin' on Cuyahoga.
drinkin koolaid's picture

As I stated in a previous comment earlier today about HG. The downtrend in HG is ending as of today because of the selling climax All the bad news is being discounted. Maybe more importantly, bullish for SILVER also, as HG has been weighing on silver. I'll be watching to go long the Shanghai also, not yet though.  I haven't bought Chinese stocks, via FXI, since Dec. of 2008. Market trends don't last forever.

The Most Interesting Frog in the World's picture

holy shit man... someting wong...

Seer's picture

Roller coaster rides are fun!

Seer's picture

Hey, where's the USS Minsky?

NOTaREALmerican's picture

Cash flow? 

I thought they printed cash flow?

Carl Popper's picture

Lol there is a limit.  


China is very opaque but I suspect they long ago printed past the point of no return. 

Carl Popper's picture



While I love to gloat and smack down china lovers this Minsky moment will affect us too.  


No telling how exposed our own banks are. 

Seer's picture

Banks and, in general, most all businesses.  Gale pretty much outlines it here:

pashley1411's picture

I was surprised to see how the Chinese economy is now so closely correlated to world growth.    With every other economy dead-in-the-water, Chinese slowing/retenching will capsize alot of boats.

Seer's picture

"I was surprised to see how the Chinese economy is now so closely correlated to world growth. "

Did you miss that they were/are a HUGE exporter?

katchum's picture

The U.S. still has more total credit market debt as a % of GDP than China.

Seer's picture

Keep in mind that it's all on paper.  However, though it's only paper it's observance, or non-observance as would be the case with defaults, what really matters is PHYSICAL.  The "test" would be to analyze each country's ability to fucntion should their borders be closed down.

Cthonic's picture

 "The 'test' would be to analyze each country's ability to function should their borders be closed down."

After chopping, which half of a siamese twin squirms longer?

moneybots's picture

" The question is when and how the system’s current instability resolves itself"


How?  Crash.  1+1 ALWAYS = 2.

Seer's picture

It's like the System reanimates itself after a crash that'll be as big as we're going to see!  Um, no...

NOTaREALmerican's picture

Re:  1+1 ALWAYS = 2.

Not so.   This is ONLY true amongst the semi-autistic math geeks.

You are forgetting the bullshit rule:   Anything + bullshit = $ ** bullshit

sex + bullshit = romance
morals + bullshit = religion.

Money to the power of bullshit.  Bullshit, ask for it by name!

Carl Popper's picture

Looks like we are gonna need a helluva lot more bullshit. 

NOTaREALmerican's picture

Re: Looks like we are gonna need a helluva lot more bullshit.

Literally...  The BEST people in the entire WORLD are working on this "challenge" right now (in a going forward space).

Gentlemen, failure is not an option! 

HardlyZero's picture

Will Yellen be the spoke (just asking) ?

Seer's picture

Oh, WAIT!  It's going to be just fine:


CEO optimism on the rise! How to play a cap-ex boom

Toolshed's picture

"a huge miss compared to current expectations of 11% earnings growth."

Rose colored glasses much? Where do these overpaid ass kissers think 11% earnings growth would come from? Have the .1%'ers announced they will all upgrade their private jet and yacht fleets this year? More stock buybacks with interest free fed funding? Huge export surge to Martian consumers? HFT skimming? What nonsense.

Seer's picture

So, I'm taking it that you have some reservations? </sarc>

Growth is dead.  All we've been doing is stealing/borrowing from the future (in hopes that unicorns will appear and save us).

youngman's picture

I would think some of the lenders in the gray market are not very nice not follow the rules..and will get paid back with either your life or something else...Mob mentality rules in China...

Seer's picture

And this is different than in the "white" market, how? (pay up commrade!)

Armed Resistance's picture

"The world will soon wake up to the reality that everyone is broke and can collect nothing from the bankrupt, who are owed unlimited amounts by the insolvent, who are attempting to make late payments on a bank holiday in the wrong country, with an unacceptable currency, against defaulted collateral, of which nobody is sure who holds title."


mumbo_jumbo's picture

"will slow only moderately as the government successfully manages to 'soft-land'"


cause as out of touch and inefficient as governments are that is the one thing that the Chinese government can get right......LOL.

The Wisp's picture

China explained in one sentence...

  Please lend me Money to pay back somebody I owe money to, I swear i will pay you back.

real's picture

BUT in the END jbm or any other government stooge,comes up empty. Why ? because when all these currencies are valued and reduced based on ability to produce, WE LOSE. simply becuase WE let our congress to sell everything we had to the bankers/wall st. so... where are we now? 

real's picture

and by the way  russia knows this and thats why i lean towards germany finally joining russia and china 


elwind45's picture

I have heard Belgium since early last night and need clarity. When you say Belgium don't you mean Swiss banking? Since Swiss peg euro would it be European to swap Belgium dollars for Swiss Euro's? And if so why you crying?

ExAureus's picture

Whoever wrote this article got it wrong. Minsky was a post-Keynesian, not a neo-Keynesian.

elwind45's picture

Maybe because Russia selling gold for Swiss/Belgium/us dollars and not doing something against its interests? Stealing from your legacy is a Yankee thing to do?

jubber's picture

China Securities Journal commentary: Corporate debt default risks have multiplied  Wow

NeverForgetSilver's picture

I have been waiting for China to crash. For the last 30 years, every day China has been on the verge of collapse according to our media. I really like to pick up some cheap investment. I even went there last year. Can these people stop bullshitting if this prediction fails again, like the rest?

kahunabear's picture

 "speculative borrowers are no longer able to roll over their debts or borrow additional capital to make interest payments"


China or US?

fattail's picture

China uses their upcoming recession and the flight to quality to unload their US treasurys on the rest of the bag holders.  Geo politics gets alot more interesting.

evernewecon's picture



How interesting that they describe

those dynamics and label it a Minsky



We're still paying for our Minsky



We're going on year 6 still waking up to

real negative interest rates on

proceeds from selling our banks'



We don't have the legitimate dynamics.


And the people knowingly sucked in

with 5/10% down should have non-recourse.




caconhma's picture

Printing money out of thin air is not always bad:

* If this funny money is invested in creation of efficient  capabilities and infrastructure to enhance economic flexibility and vitality then it is investment grade investments.

* On other hand, if new out-of-thin-air money is printed exclusively to increase consumption and for debt writing off purposes, it is a bad news since it is corrupting and destroying productive economy drivers.