One of the loudest creaking sounds coming from the markets right now is the global economy straining under a record pile of debt. The world has continued to borrow hand over fist since the financial crisis, adding nearly $US60 trillion ($83 trillion) since 2007 in the process of pushing the worldwide debt load to $US200 trillion, or nearly three times the size of the entire global economy. And that figure takes us only to 2014; we don't yet have fresh debt tallies from last year.
Hard data are often hard to find and arrives late. But no matter how you measure, global debt levels are raising alarms over whether we're on the brink of another debt-fuelled economic meltdown. The potential for disaster depends on how contagious a new round of defaults would prove - and whether writedowns in one part of the world could cause losses in others. That's what happened in the last two major debt crises, which rippled through the global economy.
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Are the markets wrong on China?
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In the late 1990s, ballooning sovereign debt loads in Indonesia, Thailand, and South Korea, combined with a default by the Russian government, kicked off back-to-back debt crises in emerging economies that required serious bailouts. Another cascade in 2008 saw the US subprime bust metastasise into the worst economic downturn since the Great Depression, infecting Europe with a sovereign debt crisis along the way.
This is why everyone is so worried about China
After the 2008 financial crisis, investors poured money into China, Brazil, and other emerging markets to take advantage of recovering commodity prices and faster-growing economies. Banks in these places turned on the spigots and unleashed a wave of new credit to households and local companies. Since 2009, the average level of private debt in emerging economies has gone from 75 per cent of GDP to 125 per cent, according to the Bank for International Settlements. Private debt levels in China and Brazil are now double the size of the national economy.
A trio of recent slides from the Bank for International Settlements is particularly eye-popping:
The hand-wringing right now concerns mostly China's debt, which has tripled since 2009 from $US10 trillion to $US30 trillion, according to McKinsey's latest estimates. The biggest increases are in China's corporate sector, where big state-owned companies gobbled up loans from big state-owned banks. Hedge fund billionaire Kyle Bass, who made a fortune betting against the US subprime crisis, is telling his investors that China's state-owned banks may take losses upward of $US3.5 trillion-four times more than what US banks got hit with during the 2008 financial crisis.
Yet lending in China continues to set records. In January, for instance, the broadest measure of credit in the country soared past expectations as banks front-loaded their 2016 lending targets in hopes of goosing short-term growth. The trouble is that no matter how much credit gets added to its economy, China's slowdown is inevitable. Adding leverage to an already leveraged system may only make the reckoning more painful.
Would a Chinese debt crisis be highly contagious?
In the traditional sense, perhaps not as much as we might think. "The levers for direct contagion have never really been there with China," says Harry Broadman, a senior fellow at Johns Hopkins University's Foreign Policy Institute and a former economist at the World Bank.
In Broadman's view, the financial mechanisms that tend to transmit default risks across economies are not as apparent. The yuan is still not fully convertible, and most of the debt in China is held in local currency, which minimises foreign exchange risks that were such a problem during the Asian crisis in the 1990s.
Most of China's borrowing also takes place through traditional bank loans, rather than through the bond market. While bonds can spread out the pain of a default or a souring credit situation among lots of investors, they also raise the risk of contagion by creating more interconnections with outside investors.
Whatever happens, it won't be 2008 all over again
That's not to say that the rest of the world is shielded from the risks of China's growing debt bomb. On the contrary, the dangers have been plain to see as worries over slowing economic growth led to a historically bad start to the year for stocks. The risk isn't a debt implosion - it's continued slow growth as China focuses more resources on managing its debt rather than trying to reform or grow.
"You shouldn't think, 'Oh my God, this is all going to collapse and China is going to default on itself,'" says Derek Scissors, a China expert at the American Enterprise Institute. "Instead, you should think, 'Oh my God, what a colossal waste of money.'"
So long as China's government is willing to backstop the country's banking system - and so far all indications are that it is - there's little chance of liquidity freezing up like it did in the fall of 2008 when US banks started running out of money. Short sellers also can't attack Chinese banks the way they went after Lehman Brothers when it was teetering on the brink.
One of the lessons of the 2008 crisis was that the US financial system was only as strong as its weakest links: highly-leveraged banks and insurance companies such as AIG. The opposite is true in China, says Scissors, where all that matters is the willingness of the state to offer support: "As soon as a bank or a company looks at risk, the government will just swoop in. So it's the strongest link that matters." The problem, he says, is that China ends up pouring good money after bad, rather than investing in growth.
China's rising debt and slowing growth have also effected its appetite for US Treasuries. For years the country stocked its surpluses into the safety of US debt. Now that those surpluses aren't as big, China's been reducing its holdings in Treasuries.
What about all that debt everywhere else?
As for the rest of the emerging market, where debt has risen the fastest, there are other reasons to be cautiously optimistic about a debt contagion being kept in check. For one, more countries have floating exchange rates than in the past, giving them the flexibility to devalue in the face of a rising US dollar. "That's made a tremendous difference," says Kenneth Rogoff, an economist at Harvard who has written extensively on the nature of debt. "In my opinion, floating exchange rates are the only reason Russia and Brazil haven't had a financial crisis yet."
These countries also hold a lot less dollar-denominated debt than in previous cycles. That's not to say a lot of borrowed dollars aren't out there that could go sour. Plenty of companies in the emerging world that took out loans in dollars yet earn in their local currencies. When the dollar was cheap, that made sense. But as the dollar has strengthened, those loans put the squeeze on a lot of companies by raising the value of their debt against the value of their revenues. According to data from the BIS, the amount of US dollar debt held by nonbanks in emerging economies stayed flat at $US3.3 trillion from June to September last year-the first time since 2009 that metric hasn't risen. It might just be evidence that companies are at least wising up.
At least we don't need to worry about one old debt nemesis
Any attempt to forecast the risk of global debt crisis wouldn't be complete without revisiting one of the main culprits from 2008: the dreaded credit-default swap.
Initially designed as a way for banks to spread risk and free up capital instead of holding it in reserve to protect against losses, the CDS was a brilliant financial innovation. But by the eve of the financial crisis, they were everywhere, hiding on the balance sheets of companies and creating unknown pathways of infection all over the world. When AIG was bailed out, it held $US440 billion of credit-default swaps on its books. By 2008, there were $US60 trillion worth of these credit derivatives around the world.
Today, the total CDS market is a fraction of that inflated size, having steadily shrunk down to $US16 trillion by the end of 2014, according to the Bank of International Settlements.
Things may still go bad, but, like always, whatever goes wrong will be different from the last time.