Bill Gross: Why Credit Creation Has Limits 1

Bill Gross on the limitations of credit creation

In his recent investment outlook, Bill Gross highlighted the high levels of leverage the global economy has reached, especially China (FXI) (YINN), where credit has doubled in the past decade.  The situation in the U.S. (SPY) (IWM) (QQQ) reminds Gross of the collapse of Lehman Brothers 

Now, while the fractional reserve banking system has played its part in fueling the growth engine of the economy by facilitating credit and lending, it has also led the global economy to a stark reality; “credit creation has limits.” By stating this, Gross meant to divert investor focus toward a key characteristic of credit expansion, that is, the cost of credit.

Must be carefully monitored

The cost of credit in an economy “must be carefully monitored so that borrowers can pay back the monthly servicing costs.” Rates, too high or too low, can create problems for the entire system.

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  1. Rates shouldn’t be too high: “If rates are too high (and credit as a % of GDP too high as well), then potential Lehman black swans can occur.” Too much credit in the system rings a warning bell for a potential asset bubble somewhere in the system. Once the bubble bursts, the leverage becomes far too expensive to service (given high rates) leading to a collapse.
  2. Rates shouldn’t be too low: “if rates are too low (and credit as a % of GDP declines), then the system breaks down.” Savers, pension funds, and insurance companies work by the capitalist model of earning a rate of return high enough to match and service their liabilities. Hence, if rates are too low, they would no longer be able to service their dues, and eventually collapse.

Now, credit creation in China has also doubled to 300% of GDP over the past decade. There is already a lot of news around China’s property bubble. Chinese billionaire, Wang Jianlin, whose net worth stood at $31.2 billion according to Forbes, who made his fortune out of China’s real estate market, warned about a bubble in late September, last year. It is the “biggest bubble in history,” he told CNNMoney during an interview.

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