In other words, valuations are higher relative to earnings, even as economic growth prospects have slowed. And it’s hard to see anything in Chinese economic conditions or policies that changed between July 2014 and June 2015 that would justify the kind of remarkable increase that preceded the recent crash.Put all these pieces together, and here’s what we have: a rise in Chinese share prices in the last year that seemed to be driven more by investor psychology than by anything fundamental. It is hard to see how the prices as of a month ago were justified, and easy to see why the sell-off of the last month would occur.That, in turn, implies that Chinese officials are fighting an uphill battle in their policy moves to try to stop the correction, and helps explain why their policy actions have had little effect so far.
Indeed. The pre-panic run-up had all the makings of irrational exuberance. Furthermore, despite the large decline in equity prices, Chinese stocks are still massively overvalued compared to where they were last fall. So unless the “Xi put” is way larger than the “Greenspan put” was back in the day, Chinese stocks still have a long way to fall.
This doesn’t necessarily mean that financial contagion will infect China’s real economy. Chinese equity markets are pretty thin and small as a percentage of GDP compared to the developed world. Less than 20 percent of household assets were in the stock market. Financially, it would be difficult to argue that this is China’s Lehman moment.
The more interesting question to ask is why the bubble was allowed to form in the first place. Here, there are some conflicting narratives. The Economist’s Free Exchange blog argues that the stock market was pumped up to enable and legitimize economic reforms:
The government has staked much credibility and prestige on the stockmarket. When the going was still good, the official press was chock-a-block with articles about how the rally reflected the economic reforms that Xi Jinping, China’s top leader, was set to push. Li Keqiang, the premier, said repeatedly that he wanted equity markets to provide a bigger share of corporate financing—comments, from punters’ perspective, not unlike waving a red cape in front of a bull. The sudden end to the rally is the first major dent in the public standing of the Xi-Li team. The botched attempts to stabilise the market only make them look weaker, giving succour to their critics.
On the other hand, writing in the Wall Street Journal, Andrew Erickson and Gabe Collins argue that the bubble happened because of bureaucratic inertia:
So why wasn’t China’s vaunted bureaucracy able to head off this policy train wreck? Well-documented bureaucratic turf wars between the People’s Bank of China (PBOC) and China Banking Regulatory Commission (CBRC) helped sow the seeds of some of China’s most pressing current economic problems—such as ballooning debt and use of shadow banking. Such infighting continues impeding the Chinese government’s response to the current market downdraft….As such, the PBOC likely faces significant political pressure to continue pumping the stock market up, as this helps distract the populace from the fact that the market for residential real estate—the prior hot investment area—is flagging. For its part, the CBRC has likely been “captured” by the very banks it is supposed to regulate, further contributing to amplified systemic risk from shadow banking activities that are tougher to track and regulate than lending conducted through normal bank channels. Ultimately, conflicting bureaucratic priorities and infighting send contradictory messages to investors and likely fuel additional market instability.
The hard-working staff here at Spoiler Alerts will leave it to the Chinese economic experts to hash out that debate. The one thing that these analysts and everyone else agrees upon is that this will put a serious dent into Xi Jinping’s efforts to liberalize the Chinese economy on issues ranging from capital account liberalization to simply letting the market play a ‘decisive’ role in the economy.
Indeed, there is no escaping the fact that China’s government has recently been extremely sensitive to what seems like minor matters. The World Bank redacted published portions of a report urging China to reform its financial sector for murky reasons, for example. And as the Financial Times’ Tom Mitchell reports, the increasingly desperate series of interventions seem odd from a policy perspective:
It is almost as if the government decided that it would manage the stock market as it does the renminbi — by setting a daily peg around which it is allowed to trade, with strict upside and downside limits.Critics who think the government has overreacted are particularly mystified by the fact that the market was not malfunctioning. Trades were closing, market participants were not failing and, if anything, a three-week, 30 per cent correction after a 12-month, 150 per cent surge seemed like a welcome adjustment.But for Mr Xi’s administration, letting the market find its own level apparently involved a loss of control — and a level of risk — that it could not accept. It does not bode well for the rest of his reform agenda.
Indeed, the China model appears to be failing this stress test. It doesn’t appear that this will have any systemic economic effects — unless this triggers a political shock of some kind. Xi Jinping has spent the past few years centralizing political power to a greater extent than anyone since Deng Xiaoping. It will be possible but difficult for him to fob off blame for this setback onto someone else. And in the mind of ordinary Chinese citizens, Xi’s leadership will not look quite so all-powerful from here on in.