As finance ministers from the Group of 20 leading economies met in Paris at the weekend, Greece's looming default raised the spectre of a global debt crisis. The eurozone's combined sovereign debt and banking troubles threaten to trigger a funding crunch in the emerging markets of Asia and the Middle East. That, coupled with China's slowing growth and mounting debts, foreshadows indebtedness that will require large-scale debt restructuring.
To avoid a second slump in less than three years, western leaders must take bold action that restores confidence in the euro zone and US public finances. Of similar importance is an end to the contagion that is spreading from Europe's banking turmoil to emerging economies. Crucially, the fate of the West and the rest increasingly depends on a "soft landing" of China's economy amid mounting worries about credit and property bubbles.
Emerging markets have $1.5 trillion (Dh5.5 trillion) worth of external debt that needs to be rolled annually. Most of it is owned by corporations and issued in US dollars. Despite high domestic saving rates, rising inflation and inadequate money markets reduce the ability of fast-growing economies to finance their liabilities.
That's why heavily-indebted companies rely on global finance to raise capital. So far European banks have provided almost 80 per cent, lending $3.4 trillion in recent years. That includes $900 billion to emerging economies in Asia and almost $500 billion to Latin America. As the IMF recently reported, "over the past year, flows into emerging market corporate external debt have surpassed flows into US high-yield debt".
In fact, a substantial share of that money comes from the US financial market. If US lenders pull the plug on Europe and if the European banking systems seize up, then the markets in Asia and elsewhere face the prospect of a mass credit crunch that could dwarf events in late 2008. Globally interconnected European banks hold over $2 trillion worth of sovereign debt from the eurozone periphery alone. A substantial write-down of Greek debt could trigger another banking crisis and plunge the West back into recession.
With nearly $3.5 trillion worth of foreign currency reserves, China might seem immune to contagion. Beijing is curbing loans to reduce high inflation and decrease rampant property speculation.
Yet China is confronted by the risk of an even greater debt crunch than other emerging markets. The main threat is a severe drop-off in external demand. With US and European growth anaemic, Chinese exports are being hit hard. All this has the potential to bring down a number of debt-ridden Chinese corporations, causing financial turmoil that would ripple through the entire economy.
The reason is that China's financial and banking system is a closely knit network of borrowers and lenders that includes an opaque structure of non-bank lending beyond the control of formal institutions like the central bank. A lack of transparency and accountability hides funding problems and delays urgent bail-outs.
Moreover, Chinese credit expansion is unprecedented in modern history. According to IMF estimates, Beijing's loan spree in response to the downturn of 2008 and 2009 raised credit from 100 per cent of national output to almost 200 per cent. This pace of loan growth is double that of Japan's stock market rally in the late 1980s and the US housing boom in the 2000s.
The Communist Party is struggling to contain the growing crisis. Aware of what happened to Dubai in 2008 the authorities have recently moved to bail out banks, prop up the highly indebted railway system and rescue insolvent cities like Wenzhou. China's railways have accumulated a deficit of $300 billion and its cities are drowning in $1.7 trillion of debt. This is fuelled by a shadow banking system of arms-length vehicles that are estimated to lend over $600 billion a year.
At the source of China's economic miracle is an unprecedented transfer of wealth from the real economy to the financial system. By suppressing real wage growth and keeping interest on household savings artificially low, the government shifts resources from ordinary families to banks and corporations with close links to the state. With barely 35 per cent of national output, consumer spending is down from 45 per cent 10 years ago and is the lowest of any big economy in the world. China's state capitalism has lifted millions of peasants out of abject misery, but the wealth of its affluent few is based on exploiting the working poor.
Boosted by an undervalued exchange rate, China's vast foreign reserves are invested in US Treasury or eurozone bonds rather than used to pay higher wages in line with strong productivity growth. In turn, the Chinese strategy has reinforced the US and European tendency to go on a debt-financed consumption spree.
All this has left mountains of debt that slow growth will never pay off. Austerity alone will kill the global recovery. A second recession will raise the real value of debt. Thus, a better option is to restructure existing debt. Concrete measures include writing off a certain proportion, lengthening the maturity of bonds and charging lower interest. The Paris Club and other recent initiatives provide examples of how to deal with unsustainable levels of indebtedness.
The G20 summit on November 3 urgently needs to agree on a comprehensive strategy to reduce global imbalances and the sea of debt in which the world economy is drowning.
Adrian Pabst is lecturer in politics at Britain's University of Kent and visiting professor at the Institut d'Etudes Politiques de Lille, France.