The Chinese stock market rise and fall is relatively unimportant for the Chinese and global economies but it has harmed the government’s reputation and may set back reform. But it if helps to kill the idea that the market can be controlled it will have some long term benefit.
There is an old joke that the stock market has predicted nine of the last five recessions. It’s usually attributed to the great US economist Paul Samuelson, who knew a lot more about markets than most academic economists do. The joke gets retold because it neatly captures the truth that stock market performance is only indirectly related to the real economy. This is particularly true of emerging markets, which are almost defined by their higher macroeconomic risk. This often takes the form of pricing a lot of hoped for future growth into a strong market, which is then vulnerable to an abrupt set back when foreign investors start to doubt. Meanwhile actual GDP growth muddles along between the extremes of crash and euphoria.
If markets are separated from the real economy in most countries, then in China they are divorced. It has been a weakness of the Chinese financial system for many years that it doesn’t have an effective stock market. A market should provide three main services: i) a place to raise capital for new businesses, private equity investors seeking an exit and state asset sales; ii) a place for investors to put funds for future growth; and iii) setting stock prices that help investors, corporations and regulators make decisions. These functions are rarely done entirely smoothly, even in rich countries. But in China they are scarcely done at all. There is a huge queue for new flotations, arising in part from a former ban by the Chinese Securities Regulatory Commission which is trying to improve governance standards. Earlier privatisations were largely about reshuffling ownership of assets within the state owned sector, apart from genuine new ownership from foreign investors, who are still restricted in what they can own in mainland Chinese stocks. And Chinese stock prices are not taken very seriously by anybody seeking genuine price signals.
Most Chinese don’t own stocks, either directly or through institutional investors (which are still relatively small in China and dominated by fixed income assets). Those that do are often like the infamous day traders of the US technology boom, avidly buying on rumours and following the herd. Day trading in the US was found to be on average extremely unprofitable. Their Chinese counterparts may still be in the money, depending on when they bought in, but many recent investments have gone badly wrong. But the overall wealth effect will be small because most Chinese savings are held in real estate, which is undergoing a much more gentle adjustment and which has better long term fundamentals.
During the peak of the bubble a few months ago, I was repeatedly told by Chinese (some of them applicants for the MFin) that the market was being driven by state actions. The government wanted the market to rise to help stimulate a slowing economy and to prepare the way for state sales of state owned enterprises at higher valuations. This apparently universal belief was encouraged by the state itself, at least through comments in state media, which acted as cheerleaders to the market. When the first market falls happened, the state duly reacted as expected by curbing short sales and forcing securities companies and other financial institutions to buy stocks. This initially reinforced the view that the state would prevail.
But eventually the horrible reality dawned. Not even the Chinese Communist Party can control the stock market. China has a Leninist political system and a broadly capitalist economy. This has worked pretty well for thirty years but depended on the state knowing the limits of its power to manipulate the economy. As Nicholas Lardy’s excellent book Markets Over Mao tells us, the state has been steadily withdrawing its control since the 1980s. The latest five year plan is far less interventionist than the earlier ones under Mao, which attempted to fix the price and quantity of thousands of goods, with the same success that planning had in the Soviet Union.
The state continued to control finance more than other sectors, chiefly through ownership of nearly all the major banks and by fixing the price of capital – the interest rate. But even this was less important than it seemed. In the rapidly growing private sector, firms increasingly funded themselves through retained earnings, just as they do in developed countries. So they didn’t care too much about bank interest rates or the lack of a proper stock market. The Chinese economic miracle happened alongside the continued direction of cheap bank loans to the state sector.
Within any government or ruling party there are factions in favour and opposing more reform, which always creates winners and losers. The reformists have been winning for some time. Indeed it’s hard to see what the alternative is for China’s economy, given the headwinds it faces from large debts, excess capacity in heavy industry and a declining workforce. The conventional wisdom, that China must rebalance towards consumption and away from investment and exports, seems correct. And that requires more market forces, not less, which is indeed state policy.
Yet the state’s apparent encouragement of the stock bubble and then inevitable failure to keep it inflated has provided ammunition for the anti-reformers, those who would ideally abolish the stock market altogether (as Lenin did). In a year of bad news for the government (weakening growth, the terrible explosion at Tianjin and growing nervousness about the scope of President Xi’s anti-corruption campaign) the stock market fiasco risks undermining the Party’s reputation for competence. The unexpected RMB devaluation in August looked to some commentators like a panicky signal that the economy was weaker than admitted, though it was also justified as part of China’s campaign to make the RMB more market-driven, in order to justify inclusion in the IMF’s basket of currencies in the SDR (special drawing rights), a decision on which is likely after September 2016. I think it’s fair to say that international confidence in Chinese policy makers is lower than it used to be.
But there may be a silver lining. If the lesson of 2015 for the state is not to try to rig the market and it becomes widely accepted that markets must be left to find their own level, then the Chinese stock market is on the way to becoming a true market, which can contribute to the greater role of market forces that China needs. The far more important near term issue is the Chinese real economy. Concerns that it is decelerating more quickly than expected may be excessive: Nicholas Lardy has also pointed out that the economy’s steady shift from manufacturing to services makes some of the weak statistics on industrial output and electricity less useful than before in measuring GDP. Retail sales statistics leave out a lot of non-retail consumer spending too. A slowdown was inevitable (and some of the former GDP growth was illusory anyway, consisting of excessive local government spending on real estate and infrastructure of doubtful value – see Michael Pettis’s blog for persuasive analysis of this). For what it’s worth (perhaps not that much) the IMF’s recent Article IV report on China estimated 2015 GDP growth at 6.8%, in line with the official target of “about 7%”.
Rebalancing the Chinese economy without too abrupt a slowdown is an enormous challenge that the world needs China to get right. The stock market turbulence, while not exactly helpful to confidence, is essentially a side-show in all of this.