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On June 24, 2016, massive selling in stock futures sent the Standard & Poor’s 500 Index (S&P 500) contracts into a limit-down trading curb. Amid the Brexit vote, E-mini futures in the S&P 500 Index dove to 1,999, dropping 5.07% before trading was halted. Investors worry that Britain’s decision to leave the European Union (EU) threatened domestic and international economic stability, as evidenced by the downgrade of U.K. sovereign debt from AA+ to AA rating. However, the recent drop in U.S. stock prices pales in comparison to the 12% plunge following the contagion caused by China’s currency devaluation in August 2015.

Renminbi Devaluation

Albert Edwards of the Societe Generale Group believes that the ongoing stealth renminbi (RMB) devaluation presents a greater danger for the worldwide economy than Britain’s exit of the EU. Since August 2015, China’s trade-weighted currency basket has tumbled 10%, continuing to decline even as the RMB/dollar exchange rate has stabilized. The devaluation of the RMB by the People’s Bank of China (PBOC) is quite foreboding as it signals considerable weakness in the world’s second largest economy. Attempting to preserve gross domestic product (GDP) growth, the PBOC has resorted to exporting deflation to prevent the contraction of the country’s largest sector, exports. Not only does this place further pressure on commodity prices, but more importantly, China’s actions risk starting a currency war. During this scenario, export-dependent countries competitively devalue their currencies, warding off deflation at the cost of global growth.

Massive Debt Burden

In addition to the brewing currency crisis, the PBOC continues to foster an increasingly precarious credit situation through an accommodative monetary policy that supports the creation of bad credit via lax regulation and cheap lending. As a result, China’s total banking assets have risen by 210% in seven years, amounting to over $31 trillion as of the first quarter of 2016. Of that $31 trillion, net debt amounts to $25 trillion, including both domestic and foreign borrowing. In fact, at the end of 2015, China’s total private and public debt stood at 350% of GDP, well above the 250 to 300% level that expert studies credit to a decrease in economic growth.

Credit Inefficiency

China has reached the highest point of debt inefficiency since 2009, requiring the input of four units of credit to produce a single unit of GDP. A large factor surrounding debt inefficiency has been the increased use of new lending by both the public and private sectors to finance existing credit obligations. In 2014, the Chinese government agreed to allow the issuance of bonds by local municipalities. Since then, the income generated from 97.5% of municipal bonds has gone to paying outstanding debt obligations. Additionally, 44% of corporate bonds issued in 2015 went to repaying existing debt, which is a considerable amount when you take into consideration that China has the highest corporate debt ratio at 160% of GDP. Moreover, the International Monetary Fund (IMF) predicts that China’s potential losses from corporate loan defaults would total over 7% of the country’s GDP. As of June 2016, China’s ratio of nonperforming loans hit 1.7%. Nevertheless, world-renowned management consulting firm McKinsey & Company’s credit analysis predicts this ratio could hit 15% in 2019 if China continues on its current path of exorbitant lending.

Rapid Pace in New Lending

Thus far, China has only expanded its rate of credit creation. In the first quarter of 2016, the Chinese economy experienced the biggest three-month surge in new borrowing on record, increasing credit by 6.2 trillion yuan and pushing the rate of new lending to more than 50% ahead of 2015’s pace. According to McKinsey & Company, if China continues its current borrowing trend, the cost of handling bad debt could appreciate from 1 trillion to 3 trillion yuan every year.

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