Is China’s sell-off a needed correction, painful but short-lived, the bust before the next boom? Or is China fated to follow Japan into two long lost decades?
I think this is not the long awaited bursting of China’s mega-asset bubble, but a rather nasty correction that will hit individual investors hard.
In Tokyo we’re waiting for the “Big One,” the mega quake that geologists tell us is overdue. As the earth trembles and everything solid seems to sway, you wonder if this is it, and then it dies down and one feels that fate has been dodged yet again.
Surely Chinese investors can appreciate that sentiment as they await the aftershocks of this week’s plunge in share prices.
The nightmare scenario is if the meltdown spills over into the property market and there’s a reckoning with the mountains of bad real estate loans everyone knows are a disaster waiting to happen.
Given that many of the punters who lost their shirts in the Chinese stock market crash probably leveraged their property to speculate, real estate might also head south. Yet, because most investors in stocks are individual investors, institutions are somewhat insulated and the government will do whatever it takes to help them ride out the storm.
President Xi Jinping, after all, doesn’t want to be remembered as the Chinese Herbert Hoover — U.S. President during the Great Depression that began in 1929 — and thus authorities have moved resolutely to stabilize the market.
Anxieties persist because rescuing the market has meant sidelining market forces and clamping down on media coverage, highlighting just how bad things are.
The government has applied the standard toolbox of policy measures and “cosmetic bandages” to stop the hemorrhaging, but as Japan well knows, this stopgap approach merely postpones the pain.
The Communist Party has overcome much adversity, often self-inflicted, but it appears to have met its match in trying to rein in market forces.
Will the meltdown stall needed economic reforms? Probably not. In fact it may provide a needed jolt of urgency.
But authorities’ suspicions about market forces have been reinforced and they may settle for half measures that undermine prospects for China’s economy, burdened as it is with overcapacity and low productivity growth.
Will the plunge undermine the Party’s hold on power? I wouldn’t bet on it because the Party can coopt the powerful, bamboozle the majority and intimidate the rest.
In post-burst Japan the Liberal Democratic Party (LDP) did lose power in 1993, but that was because of a scandal involving the yakuza — Japan’s mafia-like crime syndicate — and senior party members. It returned to power after an eleven-month hiatus. The Communist Party of China doesn’t have to deal with multi-party elections so doesn’t face this risk.
Similarities with Japan
There is a risk of exaggerating similarities between Japan 1990 and China 2015, but there are some. Chinese policy makers have undoubtedly read up on the lessons from Japan’s spectacular bubble bursting in the 1990s.
There is much to learn from Tokyo’s mishandling of that financial crisis that prolonged the pain for two decades and counting.
Essentially Japanese policymakers put off tough decisions and relied on smoke and mirrors in the hope that an economic rebound would solve all the problems.
That rebound never happened, the economy went into a balance sheet recession where firms collectively stopped borrowing (due to overcapacity and dismal economic conditions) and paid down their loans, sparking deflation.
What Japan did spectacularly wrong was hoping for the best, temporizing and pretending the crisis wasn’t so severe. The government also failed to maintain high levels of counter-cyclical spending to offset the slump in consumption and killed a fragile recovery by raising taxes.
It was not until Prime Minister Junichiro Koizumi came to power in 2001 that the government forced banks to deal with their bad loans and managed to get the financial sector off taxpayer-funded life support. But the problems had festered and grown during a decade of dithering.
Clearly the authorities in both nations stumbled in acting to contain the bubble, maintaining an easy money policy even when it was obvious that doing so was igniting an asset bubble. In both countries, stock prices soared well beyond sustainable levels.
Currently, the Japanese Nikkei stock market index is just under 20,000 yen, compared to a peak of nearly 39,000 at the end of 1989, meaning that after a quarter of a century stocks only recovered half their ground, leaving lots of investors way under water.
At the peak, the Price-Earnings (P/E) ratio (the most comment measure for valuing stock) for Japanese stocks averaged a stratospheric 70 — typically 12 is considered prudent — while in China, the pre-crash P/E ratio of the Shanghai Composite Index was around 23.
Another similarity is misplaced faith in both nations that financial mandarins have things figured out, know what to do to and will act accordingly. Sorry China, Japan’s best and brightest blew it big time in the 1990s, so its best to assume that officials are in over their heads and could easily worsen the situation with wrong moves acting on misleading lessons from Japan’s example.
Hysteria
Collective hysteria is the force behind bubbles and their bursting. Authorities belatedly seek a soft-landing scenario, try to curb the bubble but in so doing spark a stampede for the exits. Government institutions are then required to boost investments to create a floor and authorities try to jawbone the market. This is what is happening in China now and what Japan tried to do then.
The situation in China is more promising as its growth prospects are better compared to Japan’s in the 1990s, so it has better chances of climbing out of this crater. Buying Chinese stocks is the financial equivalent of riding a turbocharged roller coaster where the company responsible for maintenance has bellied up.
Not for those with queasy stomachs or an allergy to adrenalin rushes. Recall back in 2006-07 when Chinese stocks rose 600% with a peak P/E ratio of 40 on the Shanghai Index then imploded by 70%.
That boom, bust and subsequent recovery suggests that the current meltdown is not the end of the world. China weathered the 2008 Lehman Shock by shock and awe fiscal stimulus and hopes to do so again.
What China should be really worried about is a real estate market crash. In Japan, land served as collateral on loans so as land values plummeted and the economy went into a tailspin, borrowers were unable to service their debts and this meant a surge in non-performing loans secured by land that lost as much as two-thirds of its value.
Foreclosure thus offered no solution because then banks would own lots of land that was worth a fraction of the mortgages and could only sell at a great loss.
So rather than meet this crisis head on banks with the complicity of financial regulators, kept lending to zombie borrowers so that they could meet their interest payments and thus window dress the books. This scenario was based on the misplaced hope that economic recovery would reverse all the losses and make for a happy ending. This proved elusive.
A significant correction in China’s frothy property market could be a financial Armageddon and the spillover effects to the region and global economy could prove severe. Already metal prices are plummeting and hammering resource exporters like Australia and Indonesia.
As bad as Japan’s plunge was, it had relatively modest ripples overseas, but if China’s property bubble collapses, the tsunami will have widespread consequences.
