NEW YORK – The problems with China’s economic-growth pattern have become well known in recent years, with the Chinese stock-market’s recent free-fall bringing them into sharper focus. But discussions of the Chinese economy’s imbalances and vulnerabilities tend to neglect some of the more positive elements of its structural evolution, particularly the government’s track record of prompt corrective intervention, and the substantial state balance sheet that can be deployed, if necessary.
In this regard, however, the stock-market bubble that developed in the first half of the year should be viewed as an exception. Not only did Chinese regulators enable the bubble’s growth by allowing retail investors – many of them newcomers to the market – to engage in margin trading (using borrowed money); the policy response to the market correction that began in late June has also been highly problematic.
Given past experiences with such bubbles, these policy mistakes are puzzling. I was in Beijing in the fall of 2007, when the Shanghai Composite Index skyrocketed to almost 6,000 (the recent peak was just over 5,000), owing partly to the participation of relatively inexperienced retail investors.
At the time, I thought that the greatest policy concern would be the burgeoning current-account surplus of over 10% of GDP, which would create friction with China’s trading partners. But the country’s leaders were far more concerned about the social consequences of the stock-market correction that soon followed. Although social unrest did not emerge, a prolonged period of moribund equity prices did, even as the economy continued to grow rapidly.
In 2008, it was a combination of exploding asset prices and excessive household-sector leverage that fueled the global financial crisis. When such a debt-fueled bubble bursts, its effects are transmitted directly to the real economy via household-sector balance sheets, with the reduction in consumption contributing to a decline in employment and private investment. It is much harder to find circuit breakers for this dynamic than for, say, that caused by balance-sheet distress in the financial sector.
Yet the Chinese authorities seem not to have learned the lessons of either episode. Not only did they fail to mitigate the risks, underscored in the 2007 collapse, that new retail investors introduce into the market; they actually exacerbated them, by allowing, and even encouraging, those investors to accumulate leverage through margin buying.
Making matters worse, when the current stock-market correction began in early June, Chinese regulators relaxed margin-buying restrictions, while encouraging state-owned enterprises and asset managers to purchase more stocks. The authorities, it seems, were more interested in propping up the market than allowing for a controlled price correction.
To be sure, China’s stock-market bubble did not emerge until recently. Last October, when the Shanghai Composite Index was in the 2,500 range, many analysts considered equity prices undervalued. Given relatively strong economic growth, rising prices seemed justified until about March, when the market, driven by mostly thinly traded small- and mid-cap stocks, shot to over 5,000, placing the economy at risk. (And, in fact, many still claimed that the rally was not unsustainable, as the stock market was trading at a forward price-to-earnings ratio of about 15, consistent with its ten-year average, in mid-April.)
But it was a bubble – and a highly leveraged one at that. While periodic bubbles may be unavoidable, and no bubble is without consequences, a highly leveraged bubble tends to cause far more damage, owing to its impact on the real economy and the duration of the deleveraging process.
This is reflected in the persistently sluggish recovery in the advanced economies today. Even the United States, which has fared better than most since the crisis, has recorded GDP growth of little more than 10% since the start of 2008; over the same period, China’s economy grew by about 66%.
Of course, with China’s household sector holding a relatively small share of equities compared to real estate, the current stock-market slump is unlikely to derail the economy. Nonetheless, as in 2007, the prospect that lost savings will trigger social unrest cannot be dismissed, especially at a time when tools like social media enable citizens easily to share information, air grievances, and mobilize protest.
As previous crises have shown, and as the current downturn in China has highlighted, steps must be taken to mitigate market risks. Specifically, China needs prudential regulation that limits the use of leverage for asset purchases. Here, the country already has an advantage: relatively high levels of equity and low mortgage-to-value ratios typically characterize real-estate purchases by China’s household sector.
Moreover, once a market correction begins, the authorities should allow it to run its course, rather than prop up prices with additional leverage – an approach that only prolongs the correction. If Chinese regulators allow the market to correct, sophisticated institutional investors with a long-term value orientation will ultimately step in, enhancing the market’s stability. In the interim, the use of public balance sheets to purchase enough equity to prevent the market from over-correcting may be justified.
As China’s markets expand – the capitalization of the Shanghai and Shenzhen markets is on the order of $11 trillion – they are increasingly outstripping policymakers’ capacity to manage prices and valuations. The only practical way forward is for the Chinese authorities to focus on regulatory and institutional development, while following through on their commitment to allow markets to play the decisive role in allocating resources.
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Comment Commented j. von Hettlingen
China has reason to worry about the "social consequences of the stock-market correction", and it doesn't underestimate the likelihood "that lost savings will trigger social unrest". Yet it did too little to avoid a rapidly inflating bubble, that drove stock prices to dizzying heights, only to see them plunge into free-fall. This rollercoaster has been especially traumatic for a bunch of relatively unsophisticated retail investors. They were newcomers and many of them have no high-school education. They tend to exhibit the herd behaviour, which characterises the volatile nature of small, uninformed investors. When someone sells, they think the person must have good information, and they follow. If someone buys, it's exactly the same pattern, only in reverse.
But the number of this category of investors - some 50 million households - was significant and may continue to grow, if confidence were restored. Ordinary workers, shop keepers, farmers, pensioners, housewives etc. had been officially encoraged to invest in stocks, and their buying drove the prices upward. To pour retail money into the stock market was a good intention, but it should have gone to real economy instead.
After languishing for the past four years, the two Chinese stock exchange markets in Shanghai and Shenzhen suddenly took off last summer, witnessing voracious buying, selling and spectacular profit-taking. Stocks of newly listed companies soared thousands of percentage points within months of their initial public offerings. The government allowed the trend of this rising speculation, and it intervened to correct the market, when the stocks began to nosedive. It stepped in so quickly to prevent the market from collapsing, in an effort to maintain social stability. Nevertheless many retail investors don't trust their government any more and feel let down. Some say the stock market lacks information and regulation, with the government and big players pulling the strings.
Michael Spence is right about the importance of a "regulatory and institutional development" as the "only practical way forward for the Chinese authorities". Yet the leadership has to grapple with the paradox of having a communist regime, while being in charge of a highly capitalist economy, which allows "markets to play the decisive role in allocating resources". But China is quite different today, compared to the Mao era. There are signs that the role of the state is declining, withdrawing itself from the economy, while creating room for the market and the private sector. Read more
Comment Commented venze chern
A significantly objective comment.
There won't be any bubble burst in China, at least not as yet.
China's stock market capital of $11 trillion is about the size of its GDP. The current volatility will stabilize in the near future. Read more
Comment Commented Mirek Fatyga
this article inadvertently reveals the true nature of the predicament, by comparing Chinese bubble to the West's bubble which produced "unusually sluggish recovery". The reality everywhere is that rampaging, out of control manipulation of money through fraudulent credit created a fog that obscures underlying reality, even to those whose lifelong business is to observe and report on economic events, like this author.
The underlying reality is that the population growth in the second half of XXth Century outran the ability of current industrial civilization to accommodate and cope. Financial manipulation serves to obscure this underlying reality by creating a Ponzi scheme of promises that cannot be fulfilled. These schemes simultaneously destabilize societies on both ends of the development spectrum. They lead to "sluggish recoveries" and spreading inequality in the developed world, and wars, mass migrations and social explosions in the developing world as masses demand better life, which governments cannot deliver in reality, but try to deliver in theory through financial fog.
The long term solution is technological progress. I am not sure what the short term solution is, and the distressing answer may be that there is none except to endure and try to prevent a major war. It would help though to admit what the underlying problem is. Promises that cannot be met, everywhere. Read more
Comment Commented Fung Fui
China has been fighting corruption in recent years, which in my opinion is the main factor of the slowing economic growth. The prosecutions on Xi Jinping's "corrupted" enemies are almost done. Now, with most of the black money in frozen mode, government is definitely in desperate mood to capitalize the system again. Therefore, priority for social interest is low (or it is ignored altogether) as government's focus is to make sure all the wealthies are to stay in the capital market, if not pumping in more money. The flaw of this strategy is that many "wealthies" are emotional retail investors who have no intention to "capitalize" the economy but only to make a quick buck for themselves. Anyway, I think many Chinese who had been "investing" their money in Macau casinos are eagerly waiting to "capitalize" the market again. Read more
Comment Commented jagjeet sinha
'Dharmasya Moolam Artha' - The Arthashastra.
Wealth is the foundation of Dharma - The State and The Sangha cannot outsource or privatize this responsibility. The DNA of The Sangha is the defining characteristic of The CCP in Beijing and The PAP in Singapore. The Sangha itself is the oldest Multinational Organization of the World - predating The Church by 1000 years. The Sangha perhaps simultaneously creates the original seeds of Democracy itself.
To enhance understanding of State Capitalism in China, it is perhaps best to comprehend the roots of its DNA. The State plays the role of The Sangha. And brings the benefits of Global Finance to its billion believers. Hence, The State steps in when it's Capital Markets are far away from the maturity in The West. The State performs the role of maturity transformation both in commercial banking as well as investment banking - as the provider of long term capital when the country's Institutional foundations have yet to achieve maturity you can see in The West. Stock Markets in China have the opposite ratio of Institutions v Individuals trading in the markets - 15 : 85. In a sense, Contingent Capital provisions - recommended to temper financial volatility - is an act of faith when The State remains in charge.
One other characteristic defining China's finances is the ratio of Real Estate Market Capitalization v Stock Market Capitalization. China's growth has been underpinned by its Real Estate. Perhaps best visualization is that China is an enormous REIT. Fortunately grossly underleveraged at the Household level. So when prices go down a few percentages, they don't get magnified by leverage. That prevents meltdown by mortgages. The State remains in charge of the financial underlay to act proactively to prevent excessive volatility. That can cause social unrest.
Of course all of these characteristics can yet come to grief when corrections happen - as they must. Tempering the volatility remain a responsibility that The State will not outsource - due to its social ramifications. Read more
Comment Commented Tom Müller
Even Nobel laureates in economics should know, that markets do not correct themselves, esp. not stock markets. In stock markets, we do not only face bubbles. When bubbles burst, what will follow is not a correction but the same race, which blew the bubble, into the opposite direction. And this race will not stop at a reasonable level but will go as far as below normal as it was above.
That is, why it is no good idea, to let bubbles just burst. A better strategy would be to let the hot air slowly out. Otherwise the explosion, that happens, would destroy much more than just the bubble itself. Read more
Comment Commented Procyon Mukherjee
Some numbers are baffling and the world has not taken note. Chinese consumption of Steel, Aluminum and Copper have surpassed that of the per capita numbers for the developed countries; it is unreasonable to expect the growth to follow the current trajectory. The allocation of resources, if left to the market, will make a sharp correction. Read more
Comment Commented Henry Rech
The Chinese idiosyncratic predilection for rank gambling, from top to bottom, and the unwillingness of China's government to be transparent, is not conducive to a sanguine prognosis. Read more
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