[This article is a special contribution by Kazunari Shirai, Director of Global Research Institute on Chinese Issues.]
The stock markets crash across the world this time is equal to the plunge seen during the Great Depression. All gains in US stock prices made under Trump’s presidency were wiped out. The US is responding boldly and quickly with measures, such as an immediate interest rate cut by the Federal Reserve and a rescue package numbering around USD 1 to 2 trillion by President Trump. The current situation is different from past cases in that the scale of the drop in stock prices is so massive. its speed is so fast, even if at the cusp of an economic crisis. A series of astonishing numbers are coming out, such as the GDP outlook, the unemployment rate surge and the exodus of funds from emerging economies. For instance, Morgan Stanley projected the GDP growth in the US from April and June, 2020 down 30 % year-on-year and the unemployment rate at the same period at 12.8 %. The Institute of International Finance pointed out that the outflow of funds from emerging countries exceeded USD 50 billion, which was double that in the 2008 global financial crisis. These events may forebode an unpredictable and gargantuan crash of the global economy.
One of the multiple “gray rhinos” (which refer to a potential risk that is thought to highly likely cause a serious issue in the future but tends to be ignored at present. This derives from the nature of rhinos that are usually slow and calm but can stampede once they become violent.) is the debt of US corporations and emerging market, notably China (especially, debt of Chinese corporations is rising rapidly). The debt has swollen along with the other two gray rhinos, one being the massive monetary easing and the other, high stock prices. From now, the three will likely influence one another strongly and contract rapidly.
According to the Bank for International Settlements (BIS), the total debt was USD 186.6 trillion as of the end of September 2019, which is broken down to USD 53.9 trillion for the US, USD 35.0 trillion for China and USD 22.1 trillion for emerging countries (excluding China). As of the end of 2018, the total debt was USD 117.0 trillion , which is broken down to USD 35.3 trillion for the US, USD 6.7 trillion for China and USD 11.1 trillion for emerging countries (excluding China). Therefore, the total debt increased 60% in a mere year: an increase of 53 % for the US, a 5.3-fold surge for China, and a 2.0-fold rise for emerging economies (excluding China).
Limiting to debt of non-financial corporations, the total debt is USD 72.4 trillion, which is broken down to USD 16.0 trillionfor the US, USD 20.5 trillion for China and USD 8.8 trillion for emerging countries (excluding China). As of the end of 2008, the total debt was USD 45.3 trillion , which is broken down to USD 10.7 trillion for the US, USD 4.6 trillion for China and USD 4.7 trillion for emerging countries (excluding China). In the growth rate, corporate debt rose 60%, an increase of 50% for the US, an alarming 4.5-fold jump for China and a rise of 87% for emerging countries (excluding China).
Not only is the scale of the amount held by the US and China noteworthy, but the growth rate of China is also conspicuous. No single country among emerging economies other than China stands out with the amount of debt. Among emerging countries, South Korea is second to China in the outstanding amount of debt, but the country’s total debt is just USD 3.8 trillion and its corporate debt is only USD 1.6 trillion. Nonetheless, the growth rate is not necessarily low.
Firstly, the corporate debt in the US. According to the Bank of Japan, speculative corporate bonds and loans were USD 2.3 trillion as of 2018,. Even only looking at BBB bonds, the lowest credit rating (if the impact prolongs, they will surely be downgraded), stood at USD 3.2 trillion. To put the number into perspective, subprime loans, which were the true cause of the 2008 global financial crisis, were USD 1.3 trillion outstanding during the crisis, showing the graveness of the present problem. High leverage tends to have the effect of accelerating the trend either for the better or for the worse. However, if the swollen debt starts to default and leads to a negative chain reaction, debt will be sold at unexpected prices as it plunges. Thus, this typical movement have always been the driving force behind past financial crises.
This loop can start rotating regardless of where it originates, if a trigger event occurs, and the rotation starts, it is not easy to stem the movement. Generally speaking, if corporate earnings deteriorate, or concern about it worsening pushes down bond prices, companies are forced to pay back borrowings and in order to free up fund for repayment, they will stop expanding business , resulting in corporate earnings further being aggravated. Credit rating firms will downgrade such bonds, which will further accelerates the aforementioned tendency. As will be discussed later, since countermeasures against the novel coronavirus will severely hurt corporate earnings, the massive pen-up energy of this negative chain reaction is set to be let loose to financial markets.
Presently, international trade has reached about 60 % of the global GDP with supply chains built and dispersed across the world. Therefore, a long-term disruption in supply chains will largely limit both global supply and demand, and its impact on the economy will be significant. Disrupted supply chains will be restored for the first time if production activities in all countries return to normal. However, the move to exit from China as a production base, which was triggered by the Sino-US tradewar, will accelerate the disruption of supply chains. A war of words is underway between the two over where the coronavirus originated.
Theoretically, a divided trade structure, pursuit of economic nationalism, the upcoming aggressive monetary easing by central banks and massive fiscal stimulus should pave the way for inflation. Inflation may rise to a high level at the stage when demand returns to normal in the future. Additionally, it will be necessary to assume the event that food and daily necessities will be in short supply, due to the foreseeable disruption of supply chains. It is also possible that the expanding use of social media facilitates the spread of misinformation, resulting in consumers scrambling to stockpile.
It is reported that not only corporations involved with supply chains, but also tourism, restaurant, passenger transport industries and others are being severely affected by countermeasures against the novel coronavirus. CAPA – Center for Aviation, an aviation consulting firm, is sounding the alarm, that it is possible that many airline companies are seeing their cash at hand rapidly drying up, due to the suspension of flights and the decrease in passengers; it warns that many airlines will go under by the end of May. Airline companies are rushing to reduce flight services and implement unpaid holidays and other restructuring steps. The International Air Transport Association (IATA) estimates that demand of USD 113 billion will be lost globally by the novel coronavirus. The magnitude of the impact can be highlighted in light of the combined total revenue of the ANA Holdings <9202> and Japan Airlines <9201>, which is about USD 32 billion. In Italy, all non-essential factories and offices are closed in principle, and news of the suspension of automotive production in North America was put out simultaneously . Some speculate that automotive production in the US will plunge by some 80% toward the end of March. Even a probable recovery of Chinese production cannot offset the impact of production suspension in Europe and the US. Even China is in a situation that it must remain alert to a resurgence of infections, and cannot start full-scale production right now. If global sales fall to roughly 30% of usual years on a full year basis, both Toyota <7203> and Honda <7267> will likely suffer operating income losses at the several trillion yen level.
Every corporation will be forced to face a significant deterioration in earnings and some of them will fall prey to financial difficulties or bankruptcy soon. These will become catalysts that will unleash the above gray rhinos that will stampede into a negative cycle. Moreover, corporations that manage their liquidity with loans cannot solve their problems, where they cannot but raise their debt ratio, thereby becoming another fuel to a fire of future crises. Thus, this time also, a credit crunch should occur that many participants in financial markets will lose trust in current creditors, and everyone will rush to obtain funds that it is highly likely that the situation will develop into a liquidity crisis, such as the closedown of markets and the disappearance of funds. At this stage, there will have been the rise of concern over the bankruptcy of several global banks and fear of default in Southern Europe and emerging countries, causing a massive meltdown in financial markets and the economy.
Next, corporate debt in China (non-financial corporations) reached USD 20.5 trillion as of the end of September 2019, according to statistics by BIS, as mentioned at the start. This scale is equal to 150% of GDP, which tops the peak seen during Japan’s bubble economy, 147.6%. With corporate debt of the whole of emerging economies at USD 29.3 trillion, 97% of their GDP, China is overwhelming in terms of the amount. Outstanding debt of the entire emerging countries is 188% of their GDP, which is at the level of the past peak, indicating that they considerably outpace developed countries in debt growth, though not so much as China. Debt ratios are aggravating in many emerging economies (108% at the end of 2008).
Much of corporate debt in China seems to have been financed domestically. But according to Fitch Ratings, a credit rating agency, the default rate between January and December 2019 among Chinese private corporations that issued bonds on-shore is 4.9 %, a record high, a rise from 0.6 % of 2014. China’s State Administration of Foreign Exchange (SAFE) announced that China’s external debt was USD 2.0 trillion at the end of September 2019 with short-term external debt of USD 1.1 trillion included. External debt in the corporate sector (which is seemingly referred to ”others”) is USD 0.6, and short-term external debt is USD 0.4 trillion. China will use the huge amount of its foreign reserve (about USD 2.8 trillion) to make the best effort to contain the crisis, but its success is anybody’s guess. As a result, however, China’s foreign reserve, which peaked out in 2014, may further dip.
China recorded a trade deficit of USD 7.1 billion from January to February this year. If current account deficit becomes a long term trend, the possibility of the Chinese yuan further depreciating will go up. When the depreciation of the Chinese yuan gathers momentum, the burden of debt in foreign denominations will worsen. Currently, the Chinese yuan also has started to become weak against the US Dollar, though presently at a moderate pace.
Against this backdrop, the Politburo Standing Committee of the Communist Party of China was held in China on March 13, 2020, which discussed investment in new infrastructure. According to 21st Economic Report, specifically, the new infrastructure projects are mainly 5G infrastructure, industrial IoT, ultra-high voltage (UHV) electricity transmission, intercity high-speed railway and interurban train transport, new energy-driven vehicles and charging stations, big data centers and AI. It was announced that a total amount of CNY 34 trillion (USD 4.9 trillion) was to be invested in infrastructure projects in 13 provinces and cities as investment in the future key items. CNY 3 trillion (USD100 billion) will be invested during 2020. In anticipation of a looming unprecedented crisis, China intends to make bold investments with an eye to leading the world.
However, this coming crisis may have a silver lining. The novel coronavirus will significantly accelerate the transformation into a digital society. Corporations and societal structures that should have been improved in efficiency or substituted by digitization have been left to their devices due to vested interests or simply letting it be. Especially in Japan, there remains traditional and all-pervasive infrastructure, and with neither the people nor corporations having a strong sense of urgency, the tendency is noticeable. When the sophisticated face mask management by Taiwanese information technology was highlighted this time, the reality of Japan being behind the curve was brought into daylight, giving a sense defeated to the Japanese, who had been proud of themselves for being a premier, developed country in Asia. Japan’s handling of the cruise ship debacle was criticized at home and overseas, surely must have strengthened the sentiment.
At the same time, a great number of people spend more time on a digital space and have found the aggressive use of telework and electronic payment efficient. More and more business trips seem to be replaced with online meetings. Among people forced to be couch potatoes, consuming goods at home, even Seven & i Holdings <3382>, which is said to excel in brick-and-mortar business, is increasing its online sales. Educational and publishing companies are expanding sales of learning materials and electronic books. Entertainment corporations too are distributing content online free of charge and replacing physical events with video streaming. The series of such moves have been adopted mainly as responses to school suspension and self-restraint from holding events and going out. However, they may be happening partly due to the aim of certain digital industries to increase its loyal customer base. Even if self-restraint due to the coronavirus is lifted, people and corporations that recognized the benefits of digitalization anew will increase their dependence on digital services and lower its dependence on the “physical” economy. Whereas the presence of digital oriented corporations will be further reinforced, many industries that will be affected by the economic and financial crises will have to subject themselves to forced consolidation or streamlining.
Regardless of acting proactively or passively, the series of crises will force any corporation to proceed with digitalization and induce society to make a large and dynamic change. This change will widen the gap in corporate value between digital corporations and companies that have missed out on reform. This phenomenon can be readily understood by regarding this as an extension of what has happened in Japan’s and US capital markets in the past decades. In the 1980s, Japanese corporations occupied the top positions in the global market capitalization rankings. At present, however, they are a shadow of their former selves. As of March 19, 2020, Toyota’s market capitalization is USD 184 billion, followed by NTT Docomo at USD 100 billion and Nippon Telephone Telegraph Corporation at USD 83 billion. On the other hand, in the US, Microsoft is worth about USD 1.1 trillion with Apple at USD 1 trillion and Amazon at USD 918 billion, showing that the numbers of Japanese companies are one digit lower from those of the US. As a side note regarding current stock prices, Amazon lost 15 % and Netflix slipped 14% since February 19, 2020, but their corrections are light as opposed to a 32% drop of S&P 500 and a 23% loss seen with TOPIX.
Market capitalization is the present value of a future cash flow, and US companies with higher market capitalization are expected to grow in the future accordingly by investors. While the number of cars sold of Toyota was 10.84 million units in 2018, that of Tesla was 240,000 units, and the latter’s market capitalization is USD 73 billion. Tesla’s market capitalization broadly exceeds Honda, which is worth USD 36 billion with 5.32 million units sold. Theoretically, in economies of scale, the number of cars sold should be proportional to market capitalization, but this actual gap factors in vague expectations of future expansion of the number of cars to be sold by Tesla, its ability to run a company and further business growth. This proves how superior Tesla’s business model is.
This tendency is projected to increasingly strengthen in the wake of the ongoing crisis. Based on the resolve to not repeat the history of being devastated by western powers after China missed out on the Industrial Revolution, China is pushing forward with transforming itself to a digital society as a national project.
Is Japan and, Japan Inc., ready to take up the challenge? This coronavirus crisis could be its last chance. Unless Japan takes this crisis as a rare opportunity and engages in digital transformation, the only road left for Japan is the one that leads to the fall of a nation.
(This piece was written based discussions held in the FISCO Global Financial and Economic Analysis Meeting.)