How Will China’s Stock Market Drop Affect the Rest of Its Economy?
It won't drag the economy down, but it'll scare away private investors.
On July 27, the Shanghai Composite Index fell 8.5 percent, its largest single-day loss since 2007. This came on the heels of major government intervention to stem the market’s slide earlier in July. What does the latest chapter of the crash mean for China’s economy? And, more broadly, what does it mean for the policies and politics of China’s current leaders? In this ChinaFile conversation, experts discuss.
Arthur R. Kroeber, managing director of GaveKal Dragonomics, an independent global economic research firm:
People are starting to question whether the bottom is about to fall out from under China’s growth in the short term, and whether Chinese President Xi Jinping’s government is really committed to the market-oriented reforms that will create sustainable growth in the long run.
It’s clear that China has just experienced a leverage-driven bubble disconnected from the realities of economic activity and corporate earnings, and that the government has severely damaged its credibility first by encouraging retail investors to join the party and then by its mind-boggling interventions to stem the rout. Yet it is also clear that forecasts of contagion from the bear market in stocks to the real economy via a negative wealth effect among individual investors are wide of the mark. Only about 7 percent of China’s population is active in the stock market and household balance sheets are dominated by property, bank deposits and wealth management products (most of which are effectively fixed-income instruments). Equity losses will pinch household wealth, but not undermine it.
Other potential economic knock-on effects are comparably modest. Equity financing is a minor funding contributor to corporations, who rely mainly on retained earnings and bank loans. Contagion to the financial system would be a worry if brokers started going bust as a result of reckless margin lending, but this is not happening. Given the continued vitality of trading activity, value added in financial services — which boosted GDP a bit during the bull run — does not look to drop that much.
The stock market fall in itself will not drag the economy down. But the popping of the bubble has forced investors to pay attention to a fact that some were happy to ignore while stock prices rose: China’s short-term economic growth outlook is mediocre at best, and another year or two of deceleration is all but unavoidable.
The really vexing question is whether the government has the intention and the political clout to get the economy back on a sustainable track. Beijing can probably keep the economy growing by at least 6 percent through 2016, but the quality of that growth is poor, depending as it does on rising leverage and state-driven infrastructure spending. Private investment — the key to sustained productivity-driven growth — continues to decelerate. This is both because of the end of China’s long housing boom and of the financial repression that made infrastructure investment artificially cheap; and because the government has been slow to implement its promise to deregulate and open up more sectors of the economy to entrepreneurial private firms.
At several crucial points since it began economic reforms in the late 1970s, the ruling Chinese Communist Party has tactically surrendered direct instruments of control (prices, production and supply quotas, state assets) in order to enable more vibrant growth. The calculation was that the party’s legitimacy and power would ultimately benefit from a stronger economy. Xi’s Third Plenum reform document of 2013 seemed initially to call for another trade-off of this type: less direct state control, a more market-driven and efficient economy, and enhanced prestige for the party down the road.
Two years on, Xi’s top objectives are a strengthening of the party’s political mechanisms of control, and carving out a bigger role for China in global affairs. Economic reforms are at best a means to these wider ends. Putting political goals so explicitly ahead of economic ones differentiates Xi from his predecessors, all of whom stressed the primacy of economic development. In China’s present environment, where the beneficiaries of the status quo have lots of money and plenty of ability to resist change, productivity-enhancing economic reforms are unlikely to gain much more traction unless they are moved up the priority list. As the economy inexorably grinds slower over the next 18 months, the thing to watch will be whether the top party leaders signal a shift in emphasis away from political goals and towards economic ones.
Victor Shih, associate professor of Political Science at the School of Global Policy and Strategy at UC San Diego:
I think for foreign investors in general, but especially portfolio investors, the recent events represent something much more disturbing and ominous in the medium term: the Chinese equity market has become a legal swamp in which no cautious investor would want to tread. With the latest batch of rescue measures for the market, investors now face risks that are associated with destabilizing developing countries rather than the second largest economy in the world. Asset seizure, insider trading, and rampant leveraging all now are sanctioned by the Chinese government. Securities regulators also seem to rely increasingly on arbitrary enforcement from which investors have little legal recourse.
At the bottom of the crash on July 8th, China’s stock regulator rolled out the infamous “Announcement 18” which threatened “severe punishment” for any senior management or controlling shareholder — one with a stake of 5 percent or greater — for selling any shares of a listed company over the next six month. With a single announcement, trillions of RMB in assets belonging to some of China’s wealthiest investors were frozen for at half a year. Making things worse, the securities regulator announced no concrete plans for how and when major shareholders could resume selling their shares, stating instead merely that rules for future selling would be outlined in “further decrees.” In essence, there is absolutely nothing to stop the Chinese government from freezing the shares of major shareholders for another six months or even longer. It is as if their assets have been seized by the government in order to stabilize the market. This likely will have a significant implication for the economy because some of China’s wealthiest investors will need to pay a significant cost to liquidate a major part of their assets in order to invest in something else. Private sector investment likely will suffer from this illiquidity.
For foreign investors, the implications are quite stark. If the Chinese government can freeze trillions in assets of its wealthiest citizens, it certainly will not hesitate to freeze or seize the assets of foreign investors. This logic pertains to both the equities market and the fixed income market.
The other legal morass created by the Chinese rescue effort has to do with the de facto legalization of insider trading. In an effort to encourage major shareholders and senior executives to start buying shares of their companies, the authorities allowed insiders to buy shares of a company during earnings season, which previous regulations had forbidden. To be sure, this exemption only applied to companies whose shares had fallen 30 percent or more, but the vast majority of companies trading in both Shanghai and Shenzhen had seen their shares plummet by at least that much by the time the regulation was announced. As a result, insiders of most listed companies now can buy shares based on inside information without any legal ramifications. Again, it is unclear how long this emergency decree will be effective. We could see legal insider trading persist for months to come. How can pension and endowment funds in societies with much stronger rule of law justify trading in a market where inside trading is effectively legal?
Finally, Caixin revealed that banks in China had granted the China Securities Finance Corporation (CSFC) 2 trillion RMB in lines of credit, which financed its massive purchases of equities in the market. CSFC is a joint stock company owned by all the major exchanges in China with the main purpose of channeling margin financing to the brokers. When the crisis occurred, the Chinese government turned CSFC into a bailout fund, which channeled bank loans into the stock market. It turns out that CSFC’s borrowing is illegal according to a China Banking Regulatory Commission decree from 2006, which clearly states that “no corporation or individual can use bank loans to directly or indirectly invest in the stock market.” In any event, stocks became highly inflated in the first place because investors borrowed heavily to buy, and now the government wants to do so itself. This shows that prudential regulation and laws are worthless in the face of the Chinese government’s imperative to maintain stability.
To be sure, officials in the Chinese government and China optimists may proudly claim that a crisis was averted. That is true for now. However, let us also be upfront with the costs of arresting the crash for the moment — the Chinese capital market no longer has any credibility because every rule, even a fundamental rule like property rights, can be violated in the name of stability. In the face of this overriding imperative, investors have no recourse if their rights are violated or if they made losses due to the rules being ignored. Much of the hard work by Chinese technocrats and legal professionals in the past two decades to enhance the credibility of the stock market has gone to waste because of the rescue. Now, only punters who invest by guessing at the size of government intervention on a daily basis would want to wade into this market.