Debt in operationally leveraged economies

I love articles like this that state that China's debt build up is not yet a problem. They argue that because total credit is only 180% of GDP (debatable), that they can continue borrowing significantly more before it becomes a serious problem. It is true that China may continue to bubble away for a little longer, but I firmly believe that it is highly unlikely they will make it until 2018 as this article suggests before the situation gets out of hand.

The key to why China cannot sustain the same level of debt as the US is operational leverage.

Many of the best companies in the US have relatively higher and more stable margins than their competitors around the world. Coke, Johnson and Johnson, Proctor and Gamble, Google and many of the other large US companies are far less susceptible to fluctuating economics because they display more stable sales and margins. China is the opposite of this. It is the ultimate operationally leveraged economy.

China actually has numerous industries that deliberately lose money such as solar, steel production and much of their fixed asset growth purely to satisfy top line GDP growth. Not only are most of China's industries marginal, their margins are contracting due to rising wages. During the US downturn, wages have stagnated and even been reduced in Chapter 11 proceedings. I would be surprised if during a Chinese downturn the rise of the workers wages were allowed to stagnate or even fall. There is a new wave of expectation from the factory workers as they realise their power to negotiate higher wages. This trend is likely to put a great deal of pressure on margins and the economy.

Operationally leveraged businesses and economies cannot handle as much financial leverage as their higher margin counterparts.

I have no idea when China will face the music. I believe it would be prudent for them to face the facts and reduce their uneconomic growth now rather than in a few years time.  I am quite certain that when they do, they are likely to face a more pronounced slowdown than many are expecting due to the operational and financial leverage built into their system.

The Chinese leaders know the pain that will be caused by a slowing economy due to the operational leverage which is why they are yet to do much about it. There is a great deal of rhetoric about rebalancing the economy, but the imbalances continue to become greater every year. Fixed asset investment in ventures that will never cover the cost of capital and supporting loss making businesses is a dead end street, but the leaders have shown no clear sign of taking the tough measures to reverse the situation.

Those that believe in the current Chinese economic model are not comprehending the magnitude by which China is over building. Simple mathematical calculations will quickly discover that continuing the current growth rate in the number of apartments they are building in the next five years is roughly enough to house half of China with a second apartment. Use the same calculation for the number of offices they are building and the over building is expected to produce more than two offices for every man woman and child. These projections are simply not based on sustainable economics. Perhaps they have rewritten the laws of economics, but if that is the case then Australia should just give Harry Trigaboff an unending line of credit and get started building ghost cities in Alice Springs.

For all of the worlds analysts, few are focused on margin expansion and contraction, but yet it is these two forces which magnify booms and busts. Straight line projections do very little to truly analyse the economic fundamentals and where they are in their cycles. When you are close to the top of a cycle and there is potential for margin contraction in the economy and businesses, the floor (if there is one) is often a lot lower than most expect. When you throw financial leverage into the operational leverage fire, look elsewhere for your investments.