China's stocks might have been the most obvious bubble ever, and now that it's burst the government is doing everything it can to keep it from deflating any more.
For one day, at least, it was enough. The Shanghai Composite jumped 5.8 percent on Thursday to pare its losses the last month to 28 percent, while the tech-heavy Shenzhen index rose 3.8 percent to now stand 37 percent lower than it was in mid-June. This isn't quite as good as it sounds, though, since more than half of all stocks were suspended to try to stem the panic. That was one of a panoply of measures Beijing unveiled, which includes everything short of just ordering stock prices to go back up.
Now if you're a glass-half-full kind of person, you'd point that even with this sell-off, the Shanghai and Shenzhen markets are both still up around 80 percent the last 12 months. You'd also note that only 7 percent of Chinese people actually own stocks, so this market meltdown shouldn't cause an economic one. The question, though, is whether it's warning us that one is coming. And the answer is a definite maybe. Commodities have been selling off as well, in large part because people who lost money on stocks have had to sell other things to raise cash, but maybe also because Chinese factories don't have as much demand for them anymore. That'd fit, as economist Scott Sumner points out, with the fact that the Australian dollars, which tends to move in tandem with China's economy due to their close trade ties, has also been dropping. But we have to be careful about reading too much into this, since the stock market has a way of predicting six of the last two recessions. Still, there's a chance that China's stocks are falling because China's growth is falling, and not just because prices had gotten so high that they didn't make any kind of sense.
What does this mean for the rest of the world? Well, it depends on which of these is more true. If China's stock swoon is just a classic case of irrational exuberance gone wrong, then there wouldn't be too much fallout for anybody else. That's because Beijing doesn't allow foreigners to invest much in their markets—just 1.5 percent of all shares—so there wouldn't be a lot of losses outside of China.
But that calculus would change if China's economy crashes along with its markets. Now it's important to remember that "crash" is a relative term for China. Its economy is supposed to grow around 7 percent this year, so anything less than 5 percent would push unemployment up enough to feel like a recession. This kind of "hard landing" would hit the commodity countries like Russia or Australia that have been feeding China's insatiable appetite for raw materials, well, the hardest—although the ripple effects would also reach rich countries like the U.S. that actually sell $100 billion of goods to China each year. That really isn't all that much in the context of our $16 trillion economy, but if you added up how much other countries being hurt would hurt us as well, it wouldn't be nothing.
The only thing we can say for sure is that China's stocks are telling us that they have too much debt. Now, up until a year ago, the Shanghai market had been a pretty boring place to put your money considering that it'd barely gone up since its last bubble burst in 2007. But that changed when the state media began trumpeting how cheap stocks looked last fall. People listened, and then they went nuts. New trading accounts shot up, with two-thirds of them coming from people who hadn't graduated from high school. Not only that, though, but they started buying stocks with borrowed money, what's known as "buying on margin." All this new money pouring into the market—margin loans quintupled in just a year—sent stocks soaring so much that it wasn't long before stocks were going up because stocks had been going up. In other words, people were buying the shares they thought other people were buying, and not ones that actually looked good. A guaranteed winner was anything that sounded like it had to do with the internet. Indeed, a real estate company rebranded itself as P2P Financial Information Services, bought a domain name it asserted was worth $100 million, and then saw its stock surge the maximum 10 percent it was allowed to in a single day.
There might never have been a more perfect bubble. Stock prices climbed 150 percent at the same time that corporate profits were falling, economic growth was slowing, and accounting standards were as unreliable as ever. (To give you an idea about that last part, the company owned by who was China's richest man two months ago is under investigation after its stock halved in a day due to off-balance sheet shenanigans). And the fact that the boom was built on borrowed money meant that the bust would come quick. If a stock becomes worth less than you borrowed to buy it, you have to put up the difference as collateral—or, if you don't have it, be forced to sell. But forced selling makes the stock fall even more, which makes even more people face margin calls and have to sell, too. So stocks go down because stocks were going down. And the bad news right now is that markets have gone down faster than margin debt, so there are still a lot of investors out there who aren't going to have any choice but to sell.
So Beijing has tried to stop this vicious cycle by making it cheaper to buy stocks, easier to buy stocks, and helping people buy stocks, among other way of throwing money at the problem. Specifically, it's cut interest rates, let banks lend out more of their money, let pension funds buy stocks, made it easier to borrow money to buy stocks with, let people use real estate to borrow money to buy stocks with, pressured companies to buy back their own stock, barred major shareholders from selling any stock for six months, cut trading fees, capped short-selling, and suspended IPOs. Maybe the most effective thing it's done, though, is having its central bank print money—and in potentially unlimited amounts—to loan to people to buy stocks with. The idea is to put a floor under stock prices, so there aren't any more margin calls dragging them further and further down. Whether it will work for more than a day depends on how much money China really is willing to print.
But why does this matter if China's markets aren't going to sink its economy? Well, China's stocks are the canary in its coal mine of debt. Now, you probably still think of China as the workshop of the world, but the truth is that it's had to replace its export-led growth model with an infrastructure-led one—and gone on a borrowing binge in the process. So if Beijing can't figure out how to deal with its stock market debt, how would it be able to deal with its property debt, either?
The rest of the world can handle a Chinese stock market crash, but not a Chinese housing crash. That really could be 1929 with Chinese characteristics.