The nearly 9% fall in the Chinese stock market on Monday has raised concerns about a hard landing in the world’s second largest economy. Beijing is working hard to avoid economic pain in a slowing economy.
In the middle of a crackdown on political dissent and arrest of human rights lawyers, the Chinese government is used to getting its way with just about everything. But despite threats of arrest, bans on selling shares, and infusion of vast sums of money to prop up stock prices, Beijing is unable to put a full stop to the market slide.
The Chinese government is scared of losing political credibility among the investing public, but it should be more scared of financial problems it cannot tame by fiat.
So far, key stakeholders are barred from selling their stocks. The public security apparatus has been enlisted to investigate and arrest “malicious” sellers with tips provided from a public website, echoing tactics from the Maoist Cultural Revolution of the past.
The public China Securities Finance has been entrusted with $500 billion to buy shares to keep the market afloat. But Beijing’s dedication — with enormous financial and political capital — to quell panic is being severely tested with the prolonged slump and increased amount of capital required to keep the market afloat.
If history is any guide, governments that intervene to support or push down market prices do not usually succeed.
Let’s take a step back and look at the big picture. Despite official declarations of economic growth continuing at 7% per year, business barometers indicate a slowdown. This has Beijing worried. New policies have replaced tired solutions of increased investments for local governments or expanding credit for favored recipients. But the truth of the matter is that healthy economies and governments simply do not need $600 billion of forced debt restructuring and $500 billion in stock market support.
The Chinese economic boom since the global financial crisis in 2008 has been fueled primarily by debt — with total debt levels surpassing the United States. Even the recent stock market boom has been driven primarily by rising debt levels to pay for stock purchases. By one recent account, approximately 35% of freely traded shares are purchased with debt. Though the Shanghai index is still up 82% from July 2014 — driven primarily by a rapid increase in various forms of margin lending — the 27% drop since the June 8 peak has induced investor panic that Beijing is keen to avoid.
Behind the headlines, there appears little direct risk to the Chinese economy from falling equity prices, especially given the enormous gain one year ago. The real risk of a falling stock market underlies the financial fragility of the Chinese economy. Corporate profit growth is flat and producer prices are falling, making it harder for business to pay back their debts. The construction and real estate sector, responsible for nearly 30% of China’s GDP, is suffering massive oversupply throughout China and causing pricing pressures. Indebted local governments have been weighed down with unused projects and loans they cannot repay. Beijing had to order banks to continue lending even if local governments were not repaying their loans.
The underlying weakness is appearing in the international markets. Commodity prices such as oil and iron are dropping globally due to falling Chinese demand. This has weakened emerging market currencies and economies around the world used to a buoyant market for primary inputs to feed the rapidly expanding Chinese dragon.
A slowing Chinese economy has even began to drive capital out of China. One recent estimate found that $225 billion left China in the second quarter of this year.
The real risk is that the stock market collapse will join forces with the debt or currency pressures to create significant problems for the Chinese economy. Banks are already under strain from the massive local government debt restructuring and government ordered lending to support the stock market. And if firms are unable to repay their stock-linked loans easily, that could trigger a wave of selling or defaults which would create a domino effect. A falling stock market could also prompt additional capital to flee the country in a flight to safety, placing additional stress on the government imposed RMB-USD peg.
In isolation, the Chinese stock market presents little risk to the overall economy due to the low level of total stock ownership. The real risk comes from merging with other ongoing weakness, such as excessive indebtedness, in the Chinese economy.
Will we see more volatility in the Chinese stock market? Very likely. However, it remains to be seen how much the Chinese government can control an unwieldy beast that is the stock market and if they can keep the risks from spreading.
