August 6th, 2015 | By Nick Sargen
China's economy and financial system continue to be a focal point for global investors in the wake of a 30% plunge in the Chinese stock market in the past two months. The sell-off occurred against a backdrop in which the two largest markets – the Shanghai exchange and the Shenzhen exchange – had advanced by 135%-150% in the year to mid-June, after having lagged for four consecutive years.
The catalyst for the surge was the Chinese Government's efforts to encourage investors to purchase stocks in an attempt to bolster confidence in the economy and to enable state-owned enterprises to raise capital to pay down debt. This strategy appeared to be working when many retail investors became convinced that the market was headed higher and invested in it for the first time. However, when the situation proved to be unsustainable and stock prices began to plunge, policymakers responded by prodding institutions to purchase stocks while at the same time suspending trading in more than one half of publicly-traded companies. While these actions have slowed the market's decline, the situation has not stabilized thus far.
Global investors are now left wondering what the impact will be on China's economy. The prevailing view is the fallout is likely to be limited, considering that since its inception 25 years ago, share prices have lost half their value or more on three occasions; yet the economy was not severely impacted (see WSJ article on August 1). One reason is that equities are not widely held by the public: About 9% of Chinese households are estimated to have bought into the booming market when it collapsed. Therefore, the associated wealth effect is believed to be small-to-moderate.
At the same time, the buying frenzy during the run-up in stock prices appears to have had a greater effect on the economy than is widely perceived: According to BCA Research, activity in the financial services sector accounted for nearly 30% of overall growth in the first half of this year, or nearly three times the normal contribution (See BCA, China Investment Strategy, July 22, 2015.) Therefore, with activity in this sector now likely to be considerably smaller, China's policymakers could confront an added headwind in their attempt to bolster growth. Consequently, this issue is far from resolved.
Prior to these developments, the primary concern investors had about China was whether the country was at risk from a bubble in property prices. Researchers at the BIS have identified this sector to have a potentially greater impact on economies than equity markets, mainly because real estate is typically purchased with leverage and financial institutions have significantly larger exposures to this sector than to equities. Currently, China and several other emerging economies are atop the BIS watch list for asset bubbles, mainly because of the rapid expansion of credit that occurred in the wake of the 2008 global Financial Crisis. Recognizing this possibility, it is important to monitor whether the shakeout in Chinese equities will spill over to the property sector, as the consequences for China's economy would be much greater.
A relevant issue in this regard is whether China's real estate and equity markets would play out similar to Japan's experience in the 1990s or to the U.S. experience in the past decade. My own assessment is there are significant differences – most notably, China's financial system is more extensively controlled by the government than Japan's or the United States'. In the latter cases, problems in the financial system became pervasive and the process of credit creation broke down, which in turn paralyzed Japan's economy and caused the U.S. economy to contract severely in 2008-09. Furthermore, the process of re-capitalizing financial institutions via use of public funds was politically charged. By comparison, the leading financial institutions in China are predominantly government-owned or controlled and can receive government funding more easily.
A second difference is that China's policymakers have demonstrated greater flexibility in handling asset bubbles than their counterparts in Japan and the United States. The Chinese authorities, for example, sought to lessen the risk of a property bubble by raising interest rates, limiting the number of residences a single owner could buy in major cities, and levying a new tax on real estate, whereas officials in Japan and the U.S. allowed asset bubbles to build for several years. Now that the economy has softened below the government's 7% growth rate target, the Chinese authorities have responded by lowering interest rates, and they are expected to continue doing so until the economy stabilizes. By comparison, the Bank of Japan kept interest rates high well after the bubble burst, and the Federal Reserve waited for economic and financial problems to unfold before it began to ease monetary policy.
For these reasons, I do not believe a property bubble in China would unfold the way it did in either Japan or the United States. This does not mean that China would escape unscathed, however, as a bubble in either the real estate sector or the stock market is indicative of a misallocation of resources, and it would make it more difficult for China to sustain its growth rate target of 7%. Indeed, when the World Bank issued a report on China this spring, it noted that the state had gone beyond its role as a regulator and guarantor for the financial system and had engaged in more active interference in the market. Accordingly, the primary risk I envision is that continued poor resource allocation could cause China's economy to slow well below the official 7% target rate and possibly to experience the equivalent of a growth recession.
Whatever the ultimate outcome, the manner in which the Chinese authorities handled – or mishandled – the recent stock market sell-off has undermined confidence in Chinese policy-makers' commitment to economic and financial market reform. When President Xi Jingping and Premier Li Keqiang became China's new leaders in late 2012, they confronted a host of issues, the most formidable being the need to undertake structural reforms of the economy and the financial system. One year later the Government came down squarely on the side of supporting financial market reform, in which it contended that market forces would be granted the "determining" role in shaping the economy.
However, more recently, when confronted with an ongoing slowdown of China's economy, it is clear the Government once again has assigned the highest priority to achieving the country's growth objective, while relegating financial reform to the back burner. In this regard, Orville Schell, a reporter with The Guardian and a long-time observer of China, concludes:
"The obvious contradiction between a largely self-regulating financial market and a highly controlled and centralized economy is a graphic representation of China's modern-day self. What characterizes China today is that it is in the middle of a process of uncertain change in many ways. Its once purely socialist command economy is now partly socialist and partly capitalist, and it is this collision that helped trigger the drama of clashing systems and values we have been watching play out over the past few weeks." (The Guardian, July 16, 2015)
While this aptly describes what has been happening in China recently, the country's future rests on the ability of policymakers to acknowledge their mistakes and learn from them; otherwise, a further loss of investor confidence could spawn additional market declines.
We have not altered our investment strategy in the wake of the Chinese market developments, because we believe the fallout from a stock market sell-off will be limited. That said, we are monitoring the situation to see if there is spill-over to the property sector, which could have a greater impact on China's economy. Meanwhile, given the casino-like behavior of China's equity markets, investors are well advised to stay away. Furthermore, commodity prices and emerging economies are likely to continue to bear the brunt of the slowdown in China's economy.