A Major Bank Just Made Global Financial "Meltdown" Its Base Case: "The Worst The World Has Ever Seen"

When it comes to the epic bubble in China's economy, it really boils down to one - or rather two - things: a vast debt build up (by now everybody should be familiar with McKinsey's chart showing China's consolidated debt buildup) leading to a just as vast build up of excess capacity, also known as capital stock accumulation. And/or vice versa.

It is how China resolves this pernicious, and self-reinforcing feedback loop, that is a far greater threat to the global economy than even what happens to China's bad debt (China NPLs are currently realistically at a 10-20% level of total financial assets) or whether China successfully devalues its currency without experiencing runaway capital flight and a currency crisis.

One bank that is now less than optimistic that China can escape a total economic meltdown is the Daiwa Institute of Research, a think tank owned by Daiwa Securities Group, the second largest brokerage in Japan after Nomura. 

Actually, scratch that: Daiwa is downright apocalyptic.

In a report released on Friday titled "What Will Happen if China's Economic Bubble Bursts", Daiwa - among other things - looks at this pernicious relationship between debt (and thus "growth") and China's capital stock.  This is what it says:

The sense of surplus in China’s supply capacity has been indicated previously. This produces the risk of a large-scale capital stock adjustment occurring in the future. 

Chart 6 shows long-term change in China’s capital coefficient (= real capital stock / real GDP). This chart indicates that China’s policies for handling the aftermath of the financial crisis of 2008 led to the carrying out of large-scale capital investment, and we see that in recent years, the capital coefficient has been on the rise. Recently, the coefficient has moved further upwards on the chart, diverging markedly from the trend of the past twenty years. It appears that the sense of overcapacity is increasing. 

Using the rate of divergence from past trends in the capital coefficient, we can calculate the amount of surplus in real capital stock. This shows us that as of the year 2013, China held a surplus of 19.4 trillion yuan in capital stock (about 12% of real capital stock). 

Since China is a socialist market economy, they could delay having to deal directly with the problem of capital stock surplus for 1-2 years through fiscal and financial policy. However, there is serious risk of a large-scale capital stock adjustment occurring in the mid to long-term (around 3-5 years). 

Daiwa then attempts to calculate what the magnitude of the collapse of China's economic bubble would be. Its conclusions:

Even in an optimum scenario China’s economic growth rate would fall to around zero

We take a quantitative look at the potential magnitude of the collapse of China’s economic bubble to ensure that we can get a good grasp of the future risk scenario. If a surplus capital stock adjustment were to actually occur, what is the risk for China and how far would its economy fall?

Chart 7 shows a factor analysis of China’s potential growth rate. The data here suggests that (1) China’s economy has gradually matured in recent years, and this has slowed progress in technological advancement, (2) Despite this fact, it has continued to depend on the accumulation of capital mainly from public spending to maintain a high economic growth rate, and (3) As a result, this has done more harm than good to technological advancement. Between the years 2012-15 China’s economy declined, yet still was able to maintain a high growth rate of over 7%. However, 5%pt of the growth rate was due to the increase in capital stock. Labor input and total factor productivity contributed only 2%pt.

The major decline in the rate of contribution from total factor productivity is especially noteworthy, as it had maintained an annualized rate of 5% for thirty years straight since the introduction of the reform and opening-up policy and on through the era of rapid globalization.

According to a DIR simulation, if a capital stock adjustment were to occur under such circumstances, China’s potential growth rate would fall to around 4% at best. This adjustment process is shown in the bottom left Chart 7. As far as can be determined from the capital stock circulation diagram, capital spending at the level seen in 2014 should not have been allowable without an expected growth rate of over 10%. Hence if adjustment progresses to the point where the potential growth rate is only 4%, the situation for capital spending will continue to be harsh. If the adjustment process lasts from the year 2016 to 2020, capital spending will likely continue in negative numbers on a y/y basis. If this scenario becomes a reality, the real economic growth rate will hover at around zero as is shown in the  lower right portion of Chart 7.

All of this is well-known by most (or at least those who are willing to accept reality at face value instead of goalseeking it away with Keynesian theories that serve to merely perpetuate fallacious groupthink). It does, however, underscore the severity of China's economic situation and the follow-through linkages to the rest of the world. 

But where the Daiwa stands out from every other report we have read on this topic, and where it truly goes where no other research has dared to go before, is quantifying the probability of China's worst case scenario. Here is what it says:

Meltdown scenario: World economy sent into a tailspin

We have already stressed that the scenario discussed in the previous section is the optimum or bestcase scenario. What is just as likely or possibly more likely to occur is the following. If the expected growth rate declines and the progress of the capital stock adjustment causes the bad debt problem to become even more serious, the economy could spiral out of control, lapsing further into a meltdown situation. 

The stunning punchline: 

"Of all the possible risk scenarios the meltdown scenario is, realistically speaking, the most likely to occur. It is actually a more realistic outcome than the capital stock adjustment scenario.  The point at which the capital stock adjustment is expected to hit bottom is at a much lower point than in the previously discussed capital stock adjustment scenario (see Chart 8). As shown in the bottom right portion of this chart, the actual economic growth rate will continue to register considerably negative performance. If China’s economy, the second largest in the world, twice the size of Japan’s, were to lapse into a meltdown situation such as this one, the effect would more than likely send the world economy into a tailspin. Its impact could be the worst the world has ever seen."

Translated: Daiwa just made a Chinese "meltdown" and global economic "tailspin" its "realistically speaking, the most likely", base case scenario. 

And here we were thinking our calls (since 2011) that China's debt and excess capacity bubble would negatively impact global growth, are audacious. 

The question, now that Daiwa has broken the seal on Chinese and global doomsday scenarios, is whether and how soon other banks will follow in Daiwa's path, and predict an armageddon scenario which sooner or later, becomes a self-fulfilling prophecy even without the help of China's increasingly clueless micromanagers.

Credit to Zero Hedge