The world has become increasingly focused on the rapid fall of the Chinese stock market. However, this interest risks losing sight of the much more important big picture issues involved in economic and financial management. A 30 per cent drop in the stock market even in about two weeks, after a 150 per cent run up is like declaring a financial crisis after winning the lottery and the government tries to collect the taxes.A 30 per cent drop in the stock market even in about two weeks, after a 150 per cent run up is like declaring a financial crisis after winning the lottery and the government tries to collect the taxes. The flurry of activity from Beijing suggests that they are enormously worried about the political fallout from any drop in stock prices.
Holding all other things constant, I see minimal impact on the broader Chinese economy, companies, or consumers from a 30 per cent decline in the stock market. However, nothing happens with all other things constant and there are reasons to consider that this drop may be merging with some of the other problems in the Chinese economy. Even Beijing doesn’t typically give this much consideration to just political risk from small time investors.
Beijing is dealing with enormously indebted economy with debt continuing to grow at more than twice nominal GDP. Not even two months ago, China via the Ministry of Finance and People’s Bank of China mandated a large forced restructuring of provincial debt (for background read about it here and here). At the time I asked, if we changed the name from Chinese provinces to Greece, would lawyers be arguing to enforce credit default swaps with Chinese characteristics (yes, they do exist). Even officially, debt is a very real problem in China.
The Chinese economy is absolutely not growing at 7 percent.The Chinese economy is absolutely not growing at 7 percent. Electricity growth is even according to official number at 0.2 percent year-on-year; imports by volume are collapsing; commodity consumption and demand is falling or flat; corporate profit growth is essentially flat or even falling with companies relying on the stock market for profit growth; inventories in goods like cars are rising rapidly; real estate outside of the tier one cities is falling in price with large backlog of homes; real official GDP only hit 7 percent due to about 2 percent worth of deflation; producer prices are falling by almost 5 percent annually. Nothing here points to a robust economy growing at 7 percent.
So how does a fall in the stock market matter to the real economy and risks to China going forward? First, in the 2008 financial crisis cross market correlations became extremely high and there is the very real risk of similar occurrences in China. Falls in the equity markets were predated by falling real estate, commodity, RMB, and credit pricing. There is every reason to believe that multiple markets face high levels of downward pressure in China and significant falls across other assets besides equity would likely have an enormous impact. There is evidence this process is already beginning though one that Beijing is working hard to avoid. If equity market falls gather momentum and join with other markets, this could really create economic and financial turmoil in China.
Second, as the BIS noted via the Financial Times recently, in emerging markets “credit booms and real exchange rate appreciation … have historically coincided with a shift of resources from the tradable to the non-tradable sectors of the economy.” This is most certainly true in China and contributing to the increased correlations in assets discussed. With 16-20 percent of GDP accounted for in real estate in recent history and rapid growth in the financial sector from booming credit to arbitraging international interest rate differentials, a large portion of Chinese GDP is unrelated to the tradable economy. This means that any drop in asset prices, like real estate and stocks, is going to have a significant real impact.
Third, as the economy has slowed well beneath 7 percent with producer prices falling by almost 5 percent resulting in real interest rates for the best Chinese corporate of approximately 10 percent, China finds itself in a very difficult position with regards to interest rate and debt management. It desperately needs to lower interest rates but failing to attract continued capital inflows risks prompting domestic investors to flee China in even greater numbers and international investors to never come at all. In short, lowering interest rates to help lower costs for heavily indebted companies with falling prices risks turning a rapidly slowing economy into a currency crisis.
Fourth, whether the 2008 global financial crisis or the Asian financial crisis which shaped a generation of Chinese policy, asset and data quality is not what it seems. China is facing the same problem. China maintains official growth is 7 percent but enormous amounts of secondary data fails to support this and NBSC inflation data claiming urban housing residents in China enjoyed total housing CPI of only 6 percent from 2000 to 2011 reveal systematic data deficiencies. Even the state auditor in China has released reports about trying to find out how much debt Chinese provinces actually have and the enormous discrepancies between revenue and profitability of state owned companies. These hidden risks are high because we generally accept data but are surprised when what we believed is revealed as false. In short, we don’t really know, and I don’t believe Chinese policy makers have vastly superior data to outsiders, what is happening in the Chinese economy.
The drop in equity markets, most obviously, risks joining the credit market fallout from the provincial government bond program. To briefly recap, over indebted provincial governments in China received a reprieve when the MOF and PBOC mandated banks turn 6-8 percent two-to-four year loans into five-to-ten year 3.5 percent interest loans and continue lending whether borrowers were making payments or were expected to be able to repay. Reports now indicate minimal investor interest in these provincial bonds paying only slightly more than Chinese sovereign debt. These bonds aren’t being sold due to lack of investor interest due to pricing and the inability to repay debts even with significantly extended durations. Bailing out indebted provinces will cost approximately 2 trillion in bond issuance to investors sapping capital from the same firms expected to provide liquidity for stock purchases This solution, however poor in quality, allows Beijing to lower interest rates without driving investors out of China.
However, the stock market blood letting also risks joining forces with other credit problems. The PBOC and CSRC have declared repeatedly that they intend to provide liquidity to the market throughout the downturn in stocks. However, there is significant evidence that liquidity is strained and interest rates are being kept high to attract capital. With a large percentage of debt short term and significant evidence of large rollovers, the already strained definition of questionable and non-performing loans in China is raising doubts about ongoing repayment. Officially, Chinese banks are well capitalized, liquid, with low loan demand which raises the question why the PBOC would focus so consistently on increasing liquidity if banks and insurers have such large amounts of liquid and investable capital. Provincial debt problems are merely on example of liquidity strains on banks that may be rippling throughout the institutions that would typically be buyers.
I remain relatively sanguine about the direct effects from a drop in stock prices on the Chinese economy holding all other things constant. However, what concerns me now is not the fall itself but the impact this might have on these other markets. Given the amount of hidden leverage, data quality, reliance on non-operational income for firms, and downward pressure on real estate to name just a few issues, raises the issue that this could spur other movement in the Chinese economy causing additional problems. A drop in the stock market even in a weak economy is interesting to watch but won’t cause the gut wrenching gyrations and flurry of policy announcements we have witnessed. When combined with other problems that stock drop becomes major economic issues.