China has been the favorite international economic whipping boy for decades. Artificial currency devaluation, cheap manufacturing thanks to questionable human rights, lax environmental laws, corruption throughout the government, state control over much of the private sector, state-backed monopolies that suck up entire markets and talent pools, the sheer size of the Chinese workforce—pick your favorite competitive advantage, and it’s been blamed for China’s unfair success.
Predicting China’s imminent economic collapse is also a favorite perennial pastime. The quasi-communist, slowly liberalizing government’s control over China’s more capitalist enterprises has given them certain advantages on the global scale, it’s true, but it has also created certain risks. Now, it looks like China’s chickens might be coming home to roost for real, and that could mean real problems for US startups.
How China Dug Itself Into Debt
Debt, as most economists and any car salesman will tell you, isn’t a bad thing in and of itself. It provides essential fuel for startups, corporations, and national economies. Too much debt without enough productivity creates a bubble, though. And when the bubble bursts, it hits banks, companies, and consumers equally hard—and doesn’t make things too easy for governments, either. Loans stop being paid back, so banks lose value, so credit tightens up like a tickled sphincter, so businesses can’t get new loans (which they use to spur productivity and pay back old loans), and the whole thing turns into a downward-spiraling clusterfuck.
This is the situation many smarter folks than I say China is heading for.
Like much of the world, part of China’s response to the Great Recession was to make credit cheaper. I can’t claim to fully understand how central banking systems work, but this part is easy: the central bank(s) loan money to other banks, and those other banks lend to other banks, and so on down the line until the money ends up in the hands of businesses and consumers. The cheaper the central bank lends the money out, the cheaper credit is for everyone else. That means more money to grow businesses, increase productivity, and help the economy recover. It worked in the US, it worked in China, and it worked in much of the world.
But China kept its credit at rock-bottom prices for close to a decade, despite the nation’s and the world’s economic recovery. So businesses and investors have continued borrowing, and the interest payments they have to make have kept rising. A recent dip in dollar-for-dollar (or yuan-for-yuan) productivity means that earnings from borrowed money aren’t enough to pay the money back. As a result, loan defaults have doubled in a year, and two-fifths of new loans go to paying back old debts. Also, way back in 2014—just as the bubble was starting to build up steam—a full 16% of China’s 1,000 largest companies owed more in interest than their pre-tax earnings, at least on paper. Overall, China’s debt is more than 250% its annual GDP (in contrast, the US hit an all-time high debt-to-GDP ratio in the first quarter of 2016 at 105%), and well over half of that debt is corporate debt.
And yet, even in the face of this looming debt cliff, China is soldiering on with the same low-cost credit tactics. After missing it’s national GDP growth estimates, the Chinese government renewed its stimulus spending and encouraged borrowing by keeping interest rates low. This means Chinese corporations and individual investors still have access to cheap funds for now, but when the stream of money dries up it will leave behind a veritable desert—a desert with a hand extended demanding payment.
Why US Startups Should Give a Shit About China
What does this all have to do with the price of rice, right? Why should you and your roommates/co-founders care about China’s economic situation when you’re poised to be the next Facebook, Uber, or HeatsBox? For one thing, there’s that whole “global economy” thing. China is one of the biggest players in the game, and despite its internal debt problems, it’s a net creditor on the international field—China (and its banks and businesses) lends more money to other nations (and their banks/businesses) than it borrows. If China’s economy stumbles, that means less money is flowing out and more debts being called in, which means a lot less fuel for the global economic engine.
Any economic tightening is bad for the startup world. Slowdowns, even if they don’t reach the level of recessions, are inherently risky environments for all businesses, and especially for new ones. Slower business and consumer spending means any potential payoff from a startup investment is farther off in addition to being less certain, and that means entrepreneurs have an even steeper uphill battle to fight with investors.
It isn’t just the indirect macroeconomic impacts of China’s credit crisis that US startups should be worried about. China’s direct investment in US companies, including many tech startups, has ramped up in a big way in the past few years. SoFi, Uber, Lyft, AirBnB, and dozens of less well-known startups were funded, in part, by Chinese corporate, institutional, and individual investors. Total Chinese investment in US-based (almost exclusively Silicon Valley-based) startups reached more than $6 billion by the middle of last year, with more than half of that money flooding in after 2013.
This Chinese money came in just as US investors were starting to drawback from the high-risk and volatile startup world. If these foreign investors were fueled by inappropriately cheap credit, what they’ve been doing is artificially propping up the startup industry as a whole—and delaying the inevitable for many individual companies.
If and when China’s credit bubble bursts, Chinese investments in US startups are guaranteed to slow down. They may come to a screeching halt, depending on the severity of the crisis and the protectionist measures taken by the Chinese government (which may limit the amount Chinese companies and individuals can invest in foreign companies). The direct drying up of funding sources will be compounded by the increased competition for those investors that are still in the game, who will, of course, be more timid due to the global economic uncertainty China’s credit problem could trigger.
Startups that have already received funding from Chinese sources aren’t in the clear, either. They may actually be exposed to additional risks depending on the structure of their deals and their individual circumstances. First, they won’t be able to turn to their Chinese investors for future rounds of funding, meaning they’ll have to start from scratch with investors who can no longer get in on the ground floor. Chinese investors have already shown a strong preference for investing in startups early and holding back on later funding rounds, and that trend increased sharply last year. A popped credit bubble could make late-stage startup investments all but disappear.
A debt-strapped Chinese company might want to force a sale of a partially-owned startup for some quick cash. Even if a company simply sold off their stake in a startup, that’s not a signal startups want to send to other investors and will make attracting prospective investors to further funding rounds all the more difficult. Just as China’s credit crunch could mean tightened belts on a global scale, a drying up of China’s investment in US startups could end up scaring off other investors, too.
The silver lining to all of this is that China’s economy (and government) might emerge that much more liberalized and ready to join the free market world. That could mean more accessible markets, easier trade, and reduced piracy down the line. But those are all years of, if they’re on the horizon at all, while the credit cliff is fast approaching. There’s some poetic justice in the fact that it’s the Year of the Rooster because China should have everyone feeling a bit chicken.
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