Underneath the global financial system, there is a multitrillion-dollar problem that could affect the strength of huge markets in the coming years. And what is this problem? It’s the large pool of loans that companies and people all over the world are having troubles paying back. Bad debts have played a significant role on economic activities ever since the 2008 financial crisis. But in the past few months, the threats posed by bad loans have been rising. The biggest cause of concern is that of China. According to some experts, China’s bad debts may be over $5 trillion, a huge amount of money that is half the size of the annual economic output of the country.
According to official figures, Chinese banks are pulling back on their lending last December. If this continues to persist, China’s economy (the second largest in the world behind the US) may slowdown even more than it has now, which further harms many countries that have relied on China for economic growth.
However, it is not just China who is suffering from bad debts. Wherever governments and central banks have implemented aggressive stimulus policies in the past years, toxic debts had followed. In the US, it took some time for mortgage defaults to fall following the most recent housing bust. Even energy companies are having problems with paying off cheap loans to pile into the shale boom.
In Europe, experts say that bad loans amount to over $1 trillion. Many major European banks are burdened with defaulted loans, thereby complicating the efforts of policy makers to revive their economy. Italy, for example, have recently announced to clean out bad loans from the slow-moving banking industry.
Anywhere around the world, bad loans are rising at the biggest banks of Brazil, as the country struggles with the effects of a big credit binge.
“If you have a boom and then a bust, you create economic losses. You can hope the losses one day turn into profits, but if they don’t, they are a drag on the economy,” says Alberto Gallo, the head of the global macro credit research of the Royal Bank of Scotland in London.
During good financial times, people and companies acquire new loans at low interest rates in order to purchase goods and services. However, when the economies slow down, many borrowers struggle to pay off these debts. And the bigger the boom, the more bad debts there are for bankers and policy makers to deal with.
In theory, it would make sense that banks will recognize the losses in bad loans and make up for them by raising capital. The cleaned-up banks will more likely start loaning money again, which play a part in their quest for recovery.
But in reality, this approach can be difficult to implement. Recognizing losses in bad loans would mean pushing corporate borrowers to bankruptcy and households to foreclosure. Such situations may send a chill through the economy, and may have painful social consequences. In some instances, however, the banks may find it very difficult to raise additional capital in the market.