The writer, Morgan Stanley Investment Management’s chief global strategist, is author of ‘The Ten Rules of Successful Nations’

For much of this year commentators have been warning that falling yields suggest the bond market is increasingly irrational, out of touch with a rapid global recovery and misled by heavy central bank buying or the ebbs and flows of the pandemic. Now, events in China suggest the bond markets are far from clueless or crazy.
The world’s most indebted real estate developer, Evergrande, is on the verge of default. Its troubles are reverberating across China’s property sector and the world, revealing a very rational reason why long-term interest rates would not rise too far: the global economy is heavily indebted and too financially fragile to handle tighter credit conditions. We are caught in a debt trap.
China is stuck in the deep end of this quagmire. In the run-up to the global financial crisis of 2008, debt levels rose dramatically in the United States and many European countries. Since then, China has led the debt binge: private debt held by households and corporations has risen by nearly 100 percentage points to 260 per cent of gross domestic product in China, accounting for nearly two-thirds of the global increase.

Line chart of Private debt as a share of GDP (%) showing China's "debt binge"

By early 2016 China was on the financial brink. Default rates were rising rapidly. Capital was rushing out of the country. To stave off another global financial crisis, the US Federal Reserve had to abandon plans to tighten monetary policy, and Chinese authorities had to inject massive amounts of money into the financial system.
Over the next five years, China slowed much less rapidly than one would expect given the debt levels, thanks to the meteoric rise of its tech sector. The new economy, led by digital technology companies in the private sector, was virtually debt-free and grew explosively. The tech sector now accounts for a staggering 40 per cent of the Chinese economy, up from 20 per cent in 2016.

Column chart of Digital economy as a share of nominal GDP (%) showing China's surging tech sector

In the background, however, the debt bomb was still ticking. After 2016, private debts rose another 20-plus percentage points as a share of GDP, with households taking on mortgages at a record pace. Much of it went to further inflating the property bubble. About 40 per cent of the Chinese banking system’s assets are now tied to the property sector.
Evergrande’s outstanding debts of more than $300bn represent just 0.6 per cent of total credit in China, but the worry in situations like this is always about the contagion effect of any high-profile default. Before 2008, the US subprime mortgage market peaked at only $600bn before it went bust and threatened to take down the global financial system.
Most financial analysts argue that China can’t afford to let Evergrande go completely bust and risk another debt crunch. But this time politics is in direct conflict with economics.
Chinese president Xi Jinping is trying to revive a form of socialism reminiscent of the era of Mao Zedong. His government has started cracking down on the excesses of capitalism, including the wealth and power of tech tycoons, and the rampant speculation and rising debts of the property sector.
The problem: what happens in China no longer stays in China, which is the main engine of global growth. In many ways, China follows the same deformed model of capitalism as most western countries, only more so, taking on ever increasing levels of debt to generate less and less growth.
The result is growing financial fragility. Like its more advanced rivals from the US to Japan, China has created a financial system that is in constant need of government support and stimulus. Policymakers keep economic growth going at any cost, and repeatedly back down from tightening policy at the slightest hint of economic or financial trouble. Whenever a company of any consequence gets into difficulty, authorities have stepped in with a bailout. That’s especially true in China, where in recent years default rates have run far below the very low global averages.
Conditioned to expect the government to intervene in time to stave off any crisis, global investors have not pulled money out of China, yet. But if Xi were to depart from the past, by purging debts and letting defaults spike, it could trigger a nervous breakdown in the world’s financial system.

What we are likely to witness over the coming months is an epic clash between a leader with supreme powers determined to change the course of his nation, and the economic constraints imposed by gargantuan debts. For now, the markets are still betting that the stakes are too high, even for a leader as powerful as Xi, to wean China suddenly off a debt-fuelled form of capitalism the world has been practising for years.