LIVE by the sword, die by the sword. That’s what they say. In Australia’s case, the sword we’ve lived by has been China. The world’s biggest country has grown rich by feeding on our steel and coal, and we have grown rich alongside it.

But we could die by the same sword. China has developed some big problems and if they get much worse, they could cut us down.

The best way to understand China’s problems is to look back at America in 2007. There was a lot of debt all through the American financial system, but nobody knew just how much of it was bad debt. In America bad debt turned into a global financial crisis within a year, and the subsequent recession caused enormous human suffering across the world.

China has not yet had a financial crisis — and it may never have one — but its level of debt is looking pretty damn dangerous, as shown by the next chart.

Debt has pretty much doubled as a share of the economy in the last 10 years. That’s especially frightening when you consider that China’s economy has got so much bigger at the same time.

The debt has been used to keep China’s economy going strong. If you lend a company money, it hires people and makes things. Economic growth continues. The problem is not all those companies are actually profitable. Some can’t pay the money back, and you end up with bad debt.

Bad debt in China is worrying Dinny McMahon a lot. McMahon — an Australian economist and journalist who lived in China for years — recently wrote a book on the incredible scale of the economic problems in China.

“The morass of bad loans in the banking system requires the central bank to keep printing more and more money. Credit needs to continue growing to maintain economic growth, but every yuan of debt generates less economic activity than it used to,” writes McMahon.

“In theory, Beijing could allow its perpetual-motion machine of debt creation to continue indefinitely, but the newly created money eventually ends up feeding speculative bubbles, because there are few other places for it to go. In order to prevent the bubbles from popping, and to maintain confidence, the central banks prints more money.

“All the while, as the size and complexity of the system grows, the potential for something to go seriously wrong increases.”

McMahon has been watching closely as China tries to manage its bad debts. China has an intricate plan to try to deal with bad debts on the books of the banks, including an eBay-style system where members of the public can bid to buy bad debts at a discount. (Why would you do this? If you buy a million dollar loan for $5000, and there’s even a small chance they pay, you could strike it rich.)

WARNING SIGNS

McMahon is not the only one worried about China. All the major global financial institutions are on edge.

The Bank of International Settlements, for example. That’s the bank all the central banks use. It keeps a very close eye on things that could cause big banking crashes, and it does not like what it sees in China.

This next table shows a range of countries and their risks. If a country has red in any of the four columns, that’s a bad sign. China has two columns that are red. (So does Canada, where house prices have been having huge increases Australians would see as familiar. Australia has no red because while our house prices might be a bit crazy, our banks are pretty safe.)

Of course, this table is based on historical data, and sometimes it issues false alarms. While most banking crashes are preceded by a red signal, not all red signals lead to banking crashes! Nobody can predict the future perfectly. Alone, this table wouldn’t tell us much. But as another clue among many, it is helpful.

CHIEF FOR LIFE

Earlier in 2018, Chinese President Xi Jinping changed the rules to allow himself to continue as President after his current term is up. Some people think he is angling to become President for life as Mao Zedong was.

It is hard to interpret why exactly this change happened. It could just be old-fashioned lust for power. But might Mr Xi — who wants to reform the financial system — be worried about a crash? Perhaps he is even trying to ensure political stability (or, put another way, keep his job) even if the country enters a period of financial and economic turmoil?

China’s communist rule gives it some big advantages in dealing with financial crises. The government can do what it wants and doesn’t have to worry about elections. It is also far more willing to get involved in private companies. The US Government let the enormous investment bank Lehman Brothers fail in 2008 — partly on the basis that capitalism requires such failures — sparking the GFC. China would never do that.

So comparing China’s situation to America may not be apt. It is different in many ways and it may yet survive without a crash.

GROW BABY GROW

Whether China can deal with its bad debt situation depends in large part on whether it can keep growing. Debts you have when you are poor look small when you get rich. That’s how China has dealt with debt crises in the past — outgrown them. This time that plan looks trickier.

China’s GDP growth rate has already slowed considerably, as this next graph shows.

China grew its economy in the past by ramping up debt. Now debt is so high it can hardly repeat the trick. Mr Xi has said he wants quality growth, not fast growth in the new era. That means less lending to giant steelmaking firms using old USSR technology, but more to silicon chip-makers and electric vehicle-makers.

China is — according to McMahon — engaging in grand scale industrial espionage to gain the skills it needs to make those industries happen.

Given how much we need China to grow and avoid a financial crash, we probably need to barrack for it, even when its economic policies are … unusual. We live by the sword, after all, and we can’t afford for it to swing the wrong way.

Jason Murphy is an economist. He runs the blog Thomas the Think Engine.