China may not be the life raft that it was in 2008 if growing debt levels and inflated asset prices turn out to be harbingers of a new global financial crisis, Sir John Key says

Geopolitical tensions and Xi Jinping’s focus inwards mean China may not be able to help New Zealand weather a potential global downturn in the same way the Asian superpower did in the last global financial crisis, former prime minister Sir John Key has warned.

Speaking at the virtual launch of a New Zealand Initiative report on the risk of a new GFC, Key said growing debt levels, inflated asset prices and geopolitical uncertainty presented “the ingredients to what could be a very dark time in our economic future, if we’re not careful or lucky”.

Balance sheets appeared to have weakened in the last decade as central banks “pumped up the money supply enormously” and governments borrowed heavily, while recessions were getting bigger, more severe and much more connected. 

He did not agree with the view that the debt levels of governments were unimportant, saying not every country was treated equally when it came to the terms of such lending.

“We’re a little country at the bottom of the world, we’ve always paid a higher price and risk premium for the debt that we borrow. The higher those debt-to-GDP levels, the more exposed you become, and in a GFC they’re shown up to be even more.”

While some argued that countries could agree to write off government debt, history showed that much of that debt was often held by the private sector which would not necessarily be inclined to “take that hit”.

Private sector debt was also “extraordinarily high”, while research from ANZ Bank (Key is the chairman of its New Zealand board) had shown that roughly 40 percent of Australians and New Zealanders had gone into the pandemic with less than $5000 of savings in the bank.

“If you take New Zealand and you look at inflation, and look at that globally, and you make the case, as now [Reserve Bank governor] Adrian Orr is, that interest rates will have to go up, it doesn’t take too much to realise how much pressure that is going to put on households already.”

While he did not believe New Zealand’s housing market would collapse, he believed “the boom run’s over for a period of time” with the high prices at present not sustainable.

Interest rates were starting to track upwards, while the Reserve Bank was deploying tools like debt-to-income ratios and migration levels were much lower than previously.

China ‘not the life raft of ’08’

Key said geopolitical tension was also an important factor in potential financial instability, with friction in the US-China relationship having endured through the transition from Donald Trump to Joe Biden.

While China had served as the “third leg of the stool” during the last GFC, with the country’s economic growth and capacity to buy goods and services helping to prop up other nations, it was not clear it could fill the same role today – due both to some countries’ unwillingness to engage with the superpower and Xi Jinping’s push for “common prosperity” through self-sufficiency.

“Maybe China’s not the life-raft that it was in ‘08,” Key said.

Xi’s shift in economic policy had created two main victims to date, including the country’s real estate sector as fears continued to grow about the fate of heavily indebted Chinese property developer Evergrande.

“Evergrande is very large and its debt levels are huge – you know, hundreds of billions of dollars – but it’s only one of many and the question is…would the government be happy for instance to see some collapses in that area?

“Because maybe part of that would see real estate prices come down, and that’s been one of their real concerns that real estate prices are moving ever increasingly out of the reach of low- to middle-income Chinese nationals.”

The technology sector also seemed under threat, with the Chinese government having effectively halved the value of large companies like Alibaba, Tencent and Wechat through public comments and actions.

“Now maybe they consider that much of that stock or whatever is owned offshore and so they’re less worried about it, but it is an important part of their economic story that they build a smart China and so actually a highly functioning tech sector has been really important.”

“The co-existence of a major recession in 2020 with record-high sharemarket indices, record gains in US household net worth, and falling bankruptcies is bizarre and unnerving.”

The New Zealand Initiative report, co-authored by Bryce Wilkinson and Leonard Hong, warned that the United States, European Union, United Kingdom and Japan among others “seem to be walking the path to the next global financial crisis”.

“The co-existence of a major recession in 2020 with record-high sharemarket indices, record gains in US household net worth, and falling bankruptcies is bizarre and unnerving.”

Major central banks had lowered their interest rates and purchased assets to unprecedented degrees through quantitative easing, with large government deficits and extreme peacetime public debt ratios now the norm.

The current risks were in part due to the response to the last GFC, with the bailing out of financial institutions and expansion of lending – while understandable – weakening market discipline and “pumping up” public debt ratios.

Artificially low interest rates were encouraging people to borrow to buy risky assets at inflated prices, while sustaining so-called “zombie firms”, or heavily indebted companies with no future.

The worst-case scenario included plummeting asset prices, followed by financial panic and bankruptcies and unemployment on a large scale.

While there was a more optimistic outcome, based on strong and sustained economic growth and use of rising government revenue to reduce deficits, the report said that required “wishful thinking”.

Small economies like New Zealand needed to take “prudent defensive measures”, restoring net debt to appropriate levels before the next crisis and reviewing the composition and avoiding where possible commitments that would permanently increase spending. 

Wilkinson said the system’s fragility meant there were “a great many things that can tip it over”, including US-China tensions or defaults in the Chinese property market.

He described the Chinese economy as a “potential black swan”, saying the country’s lack of transparency made it difficult to gauge the scale of the problem with its high debt levels.

“China’s a bit of a dark horse, absolutely a totalitarian sort of government, so it will do whatever it can to bury the things it doesn’t want the world to see – of which economic stress would be one.”

Sam Sachdeva is Newsroom's national affairs editor, covering foreign affairs and trade, housing, and other issues of national significance.

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