China is marching into uncharted territory and here's why it should scare you

China’s inflation figures just hit a five-year low. Price growth is falling for consumers, and companies producing goods are already recording sharp deflation.

Why does it matter? One simple reason: Debt.

China’s debts as a proportion of GDP climbed from 144% in 2007 to 245% in 2014. That’s debt worth one entire Chinese economy’s total output for a year, accumulated in just seven years. That’s a lot, and it puts the country in a pretty grim situation.

Here’s how it looks:

Debt was actually falling as a portion of GDP for the few years running up to the financial crisis, before rapidly picking up afterwards.

Deflation and lower inflation only make that worse. What matters for reducing your debts is nominal growth.

The economic growth figures that you usually see strip out the effect of inflation. Nominal GDP doesn’t do that: is a simple measure of how much money there is in the economy without trying to remove the effect of rising or falling prices, and it’s very important for debt.

Michael Pettis, one of the most authoritative voices in the world on the Chinese economy, explained this during the last round of Chinese inflation data (emphasis ours):

For nearly two decades, when nominal GDP growth was as high as 20-21% and the GDP deflator at 8-10%, (economists use a deflator to remove the effect of inflation) even if they were horribly mismanaged the nominal value of assets soared relative to debt… Under those conditions it was pretty easy to ignore debt costs, and even easier to pick up very bad investment habits. Now that nominal GDP growth has dropped to around 8-10%, and could be substantially lower in a deflationary environment even if growth did not continue to decline, as I expect it will, those bad habits have become brutally expensive.

In short, it’s easy to keep borrowing if your income is growing by a fifth every year, but those habits (and your existing debts) are a lot harder to deal with if that falls to a tenth, or a twentieth. The debts you’ve made are suddenly not being inflated and grown away like they previously were. That’s what’s happening in China, and the lower both inflation and growth fall, the worse that will get.

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