Is the Chinese debt crisis a ticking time bomb for luxury?

Key points to remember:

  • Total Chinese debt across all sectors (households, government, financial and non-financial corporations) reached 318% of GDP in the first quarter of 2020, reports the Institute of International Finance.
  • Household debt rose to 57.7% of China’s GDP in the first quarter of 2020.
  • The luxury industry does not seem equipped to deal with reality. And without the Chinese super consumer, the industry cannot thrive or even survive.

Total Chinese debt across all sectors (households, government and corporates) reached 318% of GDP in the first quarter of 2020, according to the Institute of International Finance. And from the first signs, Beijing seems open to tax policies to keep the Chinese economy afloat, which will further inflate the national debt.

However, certain categories of debt are experiencing breathtaking growth. For example, the South China Morning Post reports that consumer debt has experienced and, today, is “one of the fastest growing segments of overall debt, particularly in the form of mortgages and consumer loans.” Household debt rose to 57.7% of China’s GDP in the first quarter of 2020, according to the National Finance and Development Institution. Meanwhile, China’s external debt reached $2.09 trillion in the first quarter of 2020.

In the long term, China’s rising national debt levels will create serious problems and dangers. That could stifle economic growth while forcing Beijing to fight long-term wage stagnation and moderate private consumption, creating an iterative process in which buyers have less disposable income and consume less.

China may look to US to see consequences of debt denial

The Denial of Debt is a real thing, and it has affected the way the United States does business, says John H. Cochrane, a senior fellow at Stanford University’s Hoover Institution. “The federal government borrowed nearly $1 trillion in 2019 before the pandemic hit,” he said. “It has borrowed nearly $4 trillion through the third quarter of 2020, with more to come. If we add additional and sustained borrowing of multi-trillions and $5 trillion or more to each crisis, the debt to GDP ratio will swell even with zero interest rates.

Most domestic consumers cannot understand the idea that the economic superpowers could be threatened by a sovereign debt crisis. But the default in payment has bankrupted Argentina (a country that in 1913 was the 10th richest nation in the world) and another global superpower: Russia.

Meanwhile, China faces the challenge of an aging population. According to a study by the Chinese Academy of Social Sciences, China’s population will peak at 1.44 billion by 2029, entering an “irresistible” decline. “Fewer people means less domestic consumption, and therefore a rapid slowdown in economic growth,” Said Charlie Campbellthe correspondent in East Asia for Time.

But a high national debt also represents a generational grievance, as younger consumers are punished more for miscalculations and reckless spending by older generations. Therefore, Chinese Millennials and Generation Z will be forced to embrace frugality and austerity.

China is near a tipping point. And if Beijing does not address long-term fiscal imbalances, we expect the country to run out of fiscal space to fight the next crisis. And if the COVID-19 pandemic has taught us anything, it’s that the next global crisis is always near.

What happens to the luxury industry in times of stagnant incomes and weak economic growth?

The recent post-pandemic global economic downturn shows that luxury retail is hit hard in times of economic crisis. “The impact of COVID-19 caused an unprecedented drop in market size to €217 billion, down 23% from 2019 and 2014 levels,” the 19th edition of the report reads. Bain & Company luxury study, produced in collaboration with the Fondazione Altagamma. This is the “most brutal fall ever recorded”, according to the study.

When the COVID-19 pandemic devastated the industry, the the only ray of hope was china. “Mainland China was the only major luxury market to grow in 2020,” Bruno Lannes, partner of consumer products and retail practices at Bain, told CNN Business. “The luxury market in China is now bigger than ever.”

The problem is that the luxury industry is not equipped to deal with reality. And without the Chinese super consumer, the industry cannot thrive or perhaps even survive. So when debt stress leads to shifts in demand for luxury goods, some less established high-end and luxury brands will go bankrupt.

So far, luxury brands have benefited from China’s domestic growth, which has been fueled by the more materialistic and individualistic views of younger generations. But, as these consumers age, they will be inclined to turn to discreet consumption, a form of “discreet” wealth. This could lead to internal market saturation: a phenomenon we have observed in other mature economies.

When this happens, a debt crisis will only worsen this saturation, which, in turn, will hamper the performance of the luxury industry.

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