China is the world’s second-largest economy and, in recent years, the main contributor to global growth. But that role is starting to change — and wildly. China is now acting more as a risk than a savior, and contagion within its own stock market has spread over the past week through Asia, Europe and America.
All at once, seemingly, investors have determined that China’s long-held investment-and-infrastructure growth strategy is hitting its expiration point — even though official numbers show an economy that is merely decelerating, and gradually at that. Meantime, erratic efforts of Chinese leadership to stabilize the plunging stock market have set off new questions about the wisdom of the Communist Party. Put that together — slowing growth and doubts about suits pulling the strings — and you have the makings of global chaos. Here are a few basic questions and answers about how to understand these events:
We’ve known for years that China would slow down. So why the panic?
It’s worth starting by emphasizing just how essential China has become to the global economy. It is the world’s largest manufacturer, largest merchandise trader and largest holder of foreign reserves. Over 2½ decades, China’s economy averaged nearly 10 percent annual growth — and it continued to surge in recent years, as other developed economies stagnated. On a heavy diet of oil, coal and steel, China consumed more and more of the global pie.
But, of course, the Chinese economy has always been an experiment — a market that is not-quite-free and is dominated by state-owned enterprises. That economy, too, is also guided by a party that views growth as an essential political tool: Nobody will get too frustrated with the leaders, the thinking goes, when the growth rate is the best in the world.
Only now, there are questions about whether China’s growth has been underpinned by a lot of unhealthy — and ultimately corrosive — practices. China’s rise was powered by heavy construction carried out by companies that operated free of competition. As my colleague Simon Denyer has pointed out, a lot of that construction — particularly as it pushed out into newer cities, on the promise of ever-expanding riches — now looks unwise.
Perhaps even more troubling, debt in China has exploded, and it’s those state-owned companies — long given easy credit — that hold the bulk of it. In a report earlier this year, McKinsey Global Institute noted that China’s debt has roughly quadrupled since 2007, much of it connected to the building boom. Even local governments have depended on land sales to make loan payments. Housing construction alone accounts for 15 percent of China’s GDP.
Some economists say that, particularly since the financial crisis of 2008 and 2009, China has been using “bad debt” to create unsustainable growth. In other words, 7.4 percent growth of 2014 is drastically different from, say, the 10.1 percent growth of 2004. And it’s the nature of the slowdown, rather than the pure numbers, that matter.
So why is China’s stock market reacting only now?
Let’s take a moment to state clearly that the stock market and the “real economy,” particularly in China, don’t always dance together. Until 2013, China’s major indexes were among the poorest-performing — which made almost as little sense as what happened next.
Starting about a year ago (yes, amid the slowdown), equities boomed. The Shanghai Composite Index more than doubled, and much of China was in a stock-buying frenzy, most of them mom-and-pop investors rather than major money managers. Shares looked like one of the few good investments in the country, particularly with the real estate market cooling. In a sign of how weird it got, there was even an explosion in margin lending — where individuals borrowed money against the value of their portfolios. Chinese bought stocks with virtually no mind of how the companies were actually performing. On the Shenzhen stock market, the average company had a price-to-earnings ratio of nearly 70:1; in other words, companies were valued way way way beyond their (scant) earnings. (On the Dow, by comparison, that ratio is about 16:1).
What drove this frenzy, in part, was the assumption that a slumping economy would actually help stock prices — by prompting the government to unleash a massive stimulus.
“Whenever bad news came out from the Chinese economy, very frequently the Chinese stock market would rally,” said Patrick Chovanec, a chief strategist at Silvercrest Asset Management. “There was this perverse expectation — fiscal stimulus, lending stimulus. You know, good news equals bad news.
“People were telling themselves stories, just like in the dotcom bubble. ‘The government will put more money into the economy, especially as it is going down.’”
That expectation, of course, was bound to snap back. The market got overheated and showed a drastically distorted view of China’s real economic health. Since mid-June, the Shanghai index is down nearly 40 percent while erasing all gains for the year. Many China watchers think more losses are likely in the coming weeks. The government has significant stimulus firepower, but hasn't yet unleashed it.
“There was this was a really, really leveraged market, with no historical comparison,” Chovanec said. “And that is rocket fuel on the way down.”
Why has the government had such difficulty stemming the slide?
The most basic reason is, China’s government isn’t all-powerful.
The Chinese government had been a cheerleader during the stock market’s rise, and at the first signs of stock market chaos in July, the government — through its actions — all but promised to create a floor for the market. In a series of fly-by-night steps, the government bought up shares, put new public offerings on hold (in other words, restricting new listings) and ordered major shareholders not to sell. The moves sort of worked, for a while.
But during the latest market spasms, the government has done nothing. Which is notable, because the collapse in Shanghai has coincided with a surprise move in Beijing to devalue the yuan. A weaker yuan merely added to the burden for any Chinese companies holding debt in dollars.
“The world is starting to realize China is not nearly as competent as thought, especially in the economic sphere where everyone gave it good grades,” Fraser Howie, co-author of “Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise,” told the Wall Street Journal.
Nick Lardy, an economist at the Peterson Institute for International Economics, said that China has historically propped up the market with great frequency — often enough to establish an expectation among investors.
“They had intervened in the past and had a persistent set of behaviors that led investors to believe that the government could influence stock prices,” Lardy said. “And in my view, very simply — you could never do anything that could lead investors to think that way.
“Because you can’t prop it up indefinitely.”