China Concern

The last five years have been good for most stock investors, with the Dow Jones Industrial Average gaining more than 60%.  Occasionally, I’m asked about risks that could derail this bull market.  The one big risk that I’m watching is China.   

On the surface, China may seem like an unlikely candidate to disrupt a bull market in the US.  China’s economy is still growing at an annual rate of over 6% (source: World Bank), and economic projections are that the growth rate will continue for the next several years.  History, however, suggests otherwise. 

Morgan Stanley’s Chief Global Strategist Ruchir Sharma recently wrote an interesting book titled The Rise and Fall of Nations.  In his book, Sharma points to China’s debt as a pressing concern.  “The amount of debt that China has taken in the last five to seven years is unprecedented,” he writes.  “No developing country in history has taken on as much debt as China on a marginal basis.”

It’s not so much the total debt burden, as it is the growth rate of debt that Sharma found to be the best predictor of which countries will go bust or at least experience dramatic economic slowdowns.  This month marks the 20-year anniversary of one such debt- fueled meltdown that’s worth considering.

Here is the brief story:

From the mid-1980s to the mid-1990s, Thailand’s economy grew at the fastest rate in the world.  Money flowed into the country from Wall Street as investors eagerly sought to benefit.  Mercedes sales in Thailand nearly tripled from 1992 to 1995, and the country briefly becoming the eighth largest market in the world for the luxury automobile maker.  Thai citizens developed a taste for the finer things in life, becoming the largest per capita consumer of 12-year-old scotch in the world in the mid-1990s.  

As the globalization movement of the 1990s caught on, Thailand began attracting the attention of major global companies eager to utilize the cheaper Asian labor.  Ford and General Motors were early pioneers, committing to Thailand projects of $500m and $700m, respectively, during that time. 

Literally, billions of dollars flowed into the country from similar foreign sources, some of it directed at plants and facilities; most of it, however, flowed into Thailand’s stock market or purchased speculative real estate in hopes of a quick return.  Thailand’s stock market and real estate market boomed.

In late 1996, the economy began to slow and the stock market weakened.  Headlines featured overleveraged companies struggling to meet their debt obligations.  By the summer of 1997, roughly 25% of all bank loans were either delinquent or in default.  Thailand’s stock market continued to decline.  The Thai currency began to weaken as well, as investors withdrew money from the country, and currency speculators placed bets that it would fall further.  The Thai government was forced to step in and buy the falling currency in an effort to prop it up.  The government’s currency reserves began to deplete.

In July of 1997, the government, having lost billions of dollars defending the currency, abandoned their strategy and allowed it to revalue.  Within hours of the announcement, the Thai currency (known as the baht) fell almost 20%.  It continued falling, losing 40% of its value during the next six months.  

The initial response from the US was muted, but as the crisis worsened, US markets took note, with the Dow falling 13% from August through October, 1997.  The final selloff in the US culminated in a flash crash in late October when the Dow fell 7% in one day, but recovered soon after.  As for Thailand, however, the damage to investors still remains.  The country’s stock market has yet to recover more than 20 years after the fall.  After peaking at 1,754 in 1994, the index sat at 1,561 in mid-August 2017. 

There are a few notable takeaways from the Thailand crisis.  The first is that unforeseen overseas drama can spill over into US markets and cause unanticipated losses.  More importantly, the Thailand crisis illustrates how an explosive growth in debt can derail a fast-growing economy.  According to Sharma, Thailand’s average annual increase in debt from 1992-1997 was the second highest growth rate ever recorded.  The record holder?  Present-day China, whose debt load has more than quadrupled in the last decade, growing from $7 trillion to roughly $33 trillion (Reuters). 

History is fraught with examples of countries that went on a debt binge and enjoyed years of outsized growth, but ultimately each suffered the consequences of a slowdown fueled by the over-leverage.  China may likely be no different.  Never before has a country increased its debt burden faster than China.  While a debt- fueled crisis is not imminent, it’s certainly worth watching, and it’s worth taking a moment to reflect on the 20-year anniversary of Thailand’s similar (although smaller) crisis that could be a model for future headlines. 

(Source: Rise and Fall of Nations, Ruchir Shamra, 2016)