How much debt is too much, Australia and China edition

Dr Justin Pyvis Dr Justin's picture

The TL;DR version of how much debt is too much is: it depends. If there are a plethora of attractive investment opportunities in a particular country and the local pool of savings is insufficient to fund them all, foreign savings are needed (at the right price). Fractional reserve banking by the domestic banks eases the burden somewhat - the side-effects of which are a story for another day - but when even that is not enough, offshore loans are required. That is the case in Australia. It is not, however, the case in China, which has an enormous pool of domestic savings.

But does it matter from where the debt comes? Sometimes, such as if it is denominated in a foreign currency (e.g. the Asian financial crisis), but these days most of it tends to be hedged either directly or through foreign exchange reserves. If the currency risks are properly hedged, then onshore, offshore, it doesn't matter unless you're a wacky Keynesian who actively seeks a dishonest default through the debasement of the domestic currency. Debt is debt. So while Australia is dependent upon offshore borrowing and China is not, foreign ownership of the debt should not matter for Australia given that the vast majority of Australia's gross foreign liabilities are AUD denominated or hedged, and that Australia as a whole has a net foreign currency asset position.

What really matters is the rate of growth and serviceability of the debt. Household debt to disposable income is over 100% in China, and it's over 190% in Australia. Debt levels have been growing above trend in Australia for a year now (see the indicator below), and the same is true for China. But debt serviceability, thanks to central banks the world over slashing and maintaining their cash rates at record lows, is fine.


What we have in both countries is a build-up of aggregate debt induced by artificially low interest rates running up against a wall of diminishing marginal returns. In both Australia and China, much of the debt-fuelled investment has gone into real estate. That is, unproductive, durable consumer goods as opposed to producer goods. The low hanging fruit that actually serves to boost a nation's productive output has been picked (e.g. mining investment), and so Australian productivity has been flat since 2014. It's no wonder wages are growing at their slowest rate on record even as costs rise, much to the delight of the Reserve Bank of Australia (RBA).

But it's all good - for now - because debt repayment rates are as low as they have ever been, the banks are profitable, taxation revenue grows every year and house prices continue to rise both on Australia's populous Eastern seaboard and in China. That is until debt serviceability begins to decline, asset prices stop inflating and the crisis no central banker or politician will see coming will take them completely by surprise. So yes, the amount of debt matters, but only when its serviceability reaches a point where aggregate debt cannot grow at a fast enough rate to keep the asset price appreciation party going. We're not at that point yet but when we get there, more debt will mean a harder crash in both Australia and China.