The trading year started with a bang in China.
On Monday, China’s blue-chip stock market — the CSI 300 — fell 7% in the worst trading day for four months.
The sell-off saw about $590 billion wiped from Chinese shares, according to the Bloomberg report. The fall was so steep that it triggered a break clause that suspended trade for the day.
Here’s how it looked compared to the worst of China’s stock market crashes last year in August:
The government has managed to slow the drop to a crawl on Tuesday by pumping money into the stock market.
But according to analysts from Bank of America Merrill Lynch, things could get a lot worse. They see the stock market falling by 27% in 2016 and it’s all because of the debt.
Chinese companies loaded up on debt to fuel growth between 2009 and 2014 at a faster rate than those 40 countries other countries the bank has data for. China and Hong Kong have grown corporate debt by almost 100% of GDP since 2008.
If confidence in Chinese companies’ ability to service this debt gets shaken, then they could be hit by a damaging credit crunch with investors pulling out of the risky markets. That will create a domino effect that knocks investor confidence, leading to tanking shares.
Here’s BAML (emphasis ours):
Historically, any country that grew debt this fast inevitably ran into financial system problems, including currency devaluation, banking recap, and high inflation, and we do not expect China to be an exception.
Our year-end targets had not factored in a credit crunch scenario because the timing of which is difficult to predict. Should it occur, we expect the indices to end below the low bounds, possibly substantially so.
To avoid the most dangerous form of financial instability, i.e., credit crunch, we believe that the government would need to proactively write off a significant portion of the accumulated bad debt and recap the financial system. However, we judge this scenario unlikely for various politics and practical reasons.
At the moment, government interventions are limited to buying up shares to prop up the market rather than taking on private debt. But they may be forced to.
Bank of America isn’t the only one sounding the alarm over China’s growing debt pile. The country owes almost half the world’s debt — a whopping $28 trillion — and banks like UBS and Macquarie have also both expressed concerns about the sheer size of the debt.
And, most worryingly of all, there are signs that the dominos could be starting to fall. At least 6 Chinese companies defaulted on their domestic debt last year, as companies begin to stumble under the weight.