Chinese Stocks: What’s Behind the Great Market Tumble?

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Jacques deLisle and Ann Lee on China's Stock Market Crash

The Chinese stock market rout is raising global worries. Since mid-June, the Shanghai Composite Index has fallen by about a third, and the value of the renminbi has also tumbled. Today’s troubles stem from a stimulus program — initiated by the Chinese government to shield China from the 2008 financial crisis — that pumped massive amounts of liquidity into the system. Many unsophisticated small investors jumped into the stock market, encouraged by the government. But stock valuations are turning out to be too lofty to be justified by fundamentals, especially as the Chinese economy cools down and cracks began to show. Investors — many borrowing money to invest — began to pull out, and a stampede for the exits began.

University of Pennsylvania law professor Jacques deLisle, director of Penn’s Center for East Asian Studies, says the Chinese government has taken both a carrot and stick strategy — its central bank has cut interest rates, but regulators are also investigating speculators and threatening to prosecute stock rumor mongers. It has also suspended IPOs. Ann Lee, adjunct professor of economics and finance at New York University and a U.S.-China economic relationship expert, adds that many small investors are on margin calls, which is exacerbating the sell-off. Meanwhile, it remains to be seen whether the Chinese government’s strategy will eventually work. DeLisle and Lee discussed the implications of the Chinese stock market crash on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

An edited transcript appears below.

Knowledge@Wharton: Jacques, the plunge in Chinese stocks comes from a series of moves by China’s government to shore up the markets that hasn’t worked. Where did they go wrong?

Jacques deLisle: They tried a lot of the standard tools in the toolkit. It’s a tough problem to deal with. To some extent, their approach has been mixed. The interest rate was cut by [China’s] central bank in a general attempt to [boost] the economy and have more money to perhaps go in and shore up the stock market. That’s the carrot side. We saw sticks being put in the mix, too, [such as] investigations of speculators [and] threats to prosecute those who were seen as spreading rumors about the market.

Then we went back to the sweeteners, like a $19.4-billion plan from the brokerage association (the Securities Association of China) to go in and buy up stocks; [China’s] sovereign wealth fund was going to [invest]; and the [country’s] pension fund was going to be allowed to buy some [stocks]. Then [came] one more stick — a suspension of IPOs. So they’re trying all these levers.

The general sense is they were too small to accomplish the task, and it would have taken a lot. So much of the issue is, did those steps signal to the relevant people in the market that the government was going to do what it took to step in and stop this? The world isn’t really buying that.

There are a couple reasons for that. One is that a lot of the trading [and] a lot of the shares held in the Chinese stock market are by mom-and-pop investors. They’re not institutional investors. They don’t have a long view. They’re not very sophisticated. So when the panic sets in, it tends to build. There may have been a little bit of hubris. Under the current regime, which thinks of itself as remarkably tough and dynamic and capable, this is one of the first times they’ve tried something and it hasn’t worked. That’s part of the issue.

The other [aspect] is, when we’ve seen downturns in the Chinese stock market before — and we have — it’s been volatile for many years, bracketing the global financial crisis impact. When we’ve seen those impacts before, it has been in the context of an economy that’s been growing at 10% to 12%. That heals a lot of wounds. Now, we’re seeing an economy that’s already slid to a 7% [GDP growth rate]. There’s a sense that there’s a fragility that just wasn’t there before. Twitter 

Knowledge@Wharton: Ann, where do you see the problems?

Ann Lee: I agree with his assessment overall. The [Chinese] government has been a little bit heavy handed in terms of all the measures they’ve put in place, including encouraging companies to halt trading. Because they don’t have real estate as a way to generate consumer demand, they were hoping that the stock market would get people to feel good and continue the consumer spending that they so desperately need to keep economic growth going.

It remains to be seen how successful they will be in halting this stock market rout, because when you have so many individual investors as opposed to institutional investors, and if they’re doing it in margin (with borrowed money), those margin calls are going to put pressure. It doesn’t matter what announcements come from the government; these people have to honor their individual obligations. That’s part of the problem. Whether it’s going to have a material effect on the economy remains to be seen. It’s still less than 1% of the people who are in [stock market investors]. But it’s still a significant number, more than what has happened historically in terms of [the number of] participants in the market.

Knowledge@Wharton: How can China to try and slow this down? Obviously, as Jacques mentioned, when growth in the economy is shrinking after unbelievably high levels, that’s a big factor to deal with. What is the next step, then?

Lee: China has already made lots of announcements in terms of multinational projects, such as the Silk Road (a road running through Southeast and South Asia) and the AIIB (Asian Infrastructure Investment Bank, a financial institution China initiated and 49 other countries support). Those projects are designed to be levers to generate job growth as well as other commercial opportunities that will keep the economy going. [It will also help the], other countries, getting them jumpstarted to help boost growth around the world.

This will take some time to take shape. It’s happening quickly; a lot of projects are already underway for the Silk Road. But large infrastructure projects are not as quick to materialize as stock market gains. So it’s not clear when those might be able to offset falling stock prices right now.

The Chinese government is so intent on making sure the stock market is a success, [and] so aggressive in providing liquidity to the market [that] it would be tough in the long haul for [investors] fight the government. An analogy would what the Fed (U.S. Federal Reserve) was doing in the U.S. during the financial crisis in 2008, where [it was] buying trillions of dollars’ worth of asset-backed securities to prop up the market. Eventually, it does stabilize the market and then have things turn around and start going up again. But when that will happen is unclear. But I will say that it’s usually tough to bet against government measures.

“There’s a sense that there’s a fragility that just wasn’t there before.” –Jacques deLisle

Knowledge@Wharton: Jacques, what do you see as maybe the next avenue for the government?

DeLisle: They are committed to keeping the stock market from tumbling. But it may require more efforts than have been undertaken so far. Compared to what we saw in the U.S. in terms of government actors — the Fed buying up equities — China has been fairly small-bore. If you think back to the global financial crisis, China’s stimulus package was, as a percentage of GDP, a good deal larger than the U.S.’s, and went into infrastructure projects, shoring up banks and things like that. If they’re following the U.S. playbook and doing what we did — only more so — you could see that happening if this continues.

But there is a real issue here. There is a certain ambivalence about getting too far into this. Yes, they don’t want the stock market to fall because of the possible ripple effects in the economy, particularly the impact on those consumers who were counting on those run-ups, as well as a more general sense of confidence in, and a view of, the competence of the government. They’re very sensitive to that. They can’t afford a big hit when they’re trying to do some very controversial things. That puts a lot of pressure to get in and do something to keep this [stock market slump] from happening.

The problem is it coexists with two things. One is that this kind of intervention cuts against a lot of the reforms they’ve been trying to undertake. The idea has been to move the stock market away from a merits-based listing to a disclosure-based listing to allow more companies to have access that aren’t just a big stabling to blue chips, or the red chips in the Hong Kong market, behind which the state stands, and where they have lots of policy levers. The biggest hits to stocks have … been to the smaller entities that are more recent entrants to the market. Do you abandon liberalization to shore up the market? In which case, everybody wonders how serious you are about liberalization.

The other [factor] is that it’s not as simple a stock market as it used to be. It is bigger [and] it has a more diverse set of companies. Although, by international standards, it is still closed, it is more open [than earlier]. [Therefore,] the levers don’t work quite as effectively as they would have with a smaller stock market and a narrower range or types of companies listed on it.

Knowledge@Wharton: Ann, we saw so much incredible growth from China over the last few years, and then saw it dipping down. Is this a correction going on in its economy?

Lee: It’s impossible for an economy the size of China to grow at double digits forever. There are limits to that. To put it in perspective, if China were to grow at 10% now, it would be like growing the size of Saudi Arabia in one year. That’s almost impossible to achieve. Yes, China inevitably has to slow down. Just how slow is debatable. The [Chinese] authorities have long been signaling that they want to focus on quality of growth as opposed to quantity of growth. This is partly because they want to respond to pollution and inequality concerns.

The growth certainly will taper off. But they want to ensure that people will still be employed. At this point, that doesn’t seem to be an issue. Unemployment is low in China. The labor market is quite tight and wage growth is in double digits. If it’s a slowdown like Japan, it’s probably unlikely given the other initiatives that China has on board. But yes, it could be a hiccup. That’s not unusual, given that all economies have periods of slower growth.

Knowledge@Wharton: How much of a factor is oil in this? The volatility of the oil markets, especially recently, has been a factor in this. Also, there is a glut of oil in the market right now.

Lee: It certainly would help China, because China is not exporting oil – it has been importing oil. Cheaper energy certainly has fueled economic growth. It could ease any slowdown in other parts of the economy. As China tries to gear up for more infrastructure building, then cheaper energy will aid its goals.

“A lot of the shares … in the Chinese stock market are [held] by mom-and-pop investors. They’re not institutional investors. They don’t have a long view. They’re not very sophisticated. So when the panic sets in, it tends to build.” –Jacques deLisle

Knowledge@Wharton: As Ann mentioned, Jacques, when you’re talking about infrastructure, you can’t snap your fingers and have it happen overnight — it’s a longer process. But it is an important part of what China needs to build out, especially in some remote parts of the country.

DeLisle: Yes. it’s not “snap your fingers,” but it’s closer to “snap your fingers” in China than it is in many other countries, including this one (the U.S.). You don’t have to worry about too much in the way of neighbor protests and that sort of thing. You’re right — it takes time. Much of what has been on the agenda of the current leadership is to build out the infrastructure. There’s still building going on in the core eastern cities. But a lot of it is going inland [and] in particular, attempts to build transportation links across Central Asia. Those are big investments. They obviously do generate economic growth.

But here again, we have a bit of ambivalence. [Infrastructure build-out] is something they are pushing for, absolutely. It’s a core part of the development strategy and the growth strategy. But at the same time, China has been, for several years now, trying to rebalance its economy away from a reliance on exports, which is a shrinking market overall, to some degree. It certainly can contribute less to the rapid growth of an economy the size of China’s, given how big China’s economy is now.

[China has] also been trying to rebalance away from investment and toward consumption. What’s scary about the stock market impact is, to some degree — what does it do to consumer confidence? But the 30% fall followed 150% run-up. The people who got slaughtered are [those investors] that got in at the last moment. For a lot of people who are in for the longer haul, or if you look at the size of the stock market relative to the economy, what’s your baseline? If it’s the peak of the one-year run-up, this looks terrible. If you dial back to the period after the initial recovery from the global financial crisis, it’s not so bad.

The concern is more [about] this unraveling effect. People who get called on margin calls go broke. People who decide they don’t have the money they thought they had won’t spend. How big is that effect going to be? Maybe not huge, but it’s a drag on this strategy of shifting toward consumption. The biggest concern about growth in the Chinese economy is [over the] 7% [GDP growth target] that was going to happen.

They were going to come down from 10% or 12% [targets]. But the question is how much [of that] 7% being sustained by throwing everything at it? If you’re getting 7% with stimulus packages, propping up the stock market and big infrastructure packages, what does that suggest the real, underlying growth rate is absent those interventions? That’s where the worries are starting to set in.

Knowledge@Wharton: If that 7% ends up being 3% or 4% of true growth because you’re adding in all this stimulus, then the [future of the] economy is an even bigger concern.

DeLisle: Right. Or if you can sustain 7% only by going to relatively high-bore tools, and you constantly [have] the pedal to the metal, then what does that do? You may get 7%, but can you really sustain those tools?

Knowledge@Wharton: Ann, in terms of the Chinese economy right now, what’s the most important area of focus for people outside the country?

Lee: They (the Chinese government) certainly are trying to push consumer [product industries] and services. Even though there is a stock market route, it doesn’t necessarily mean that there won’t be continued growth in those areas. Obviously, not everyone is in the stock market. You’re talking about usually the wealthy folks who invest in lots of property historically. This is their play money in the stock market. If they get dented, is that going to affect everybody else?

Then you have the fact that China still has trillions of dollars of foreign reserves. Even though you don’t want to see the government initiating all the reasons for growth and juicing it up, they still have a lot of firepower there.

For the foreseeable future, the Chinese government [will] take the lead whenever there is instability in the economy and use those reserves to stimulate the economy through infrastructure building, through whatever liquidity that it needs to put into the economy. This should give the rest of the world a sigh of relief. I don’t think China’s going to be falling apart like Greece. It’s not going to be the next shoe to drop.

Knowledge@Wharton: Jacques?

DeLisle: Yes, that’s right. There is both a lot of capacity and a lot of will, right? This is a regime which has vast financial resources, has very smart people doing economic policy, and is deeply committed to keeping the growth rate at some range. Most people talk about a 7% target now, and [China has] a lot of means to do that.

The concerns are — how long can you do that? For the relevant future, [and] for anything anybody’s looking at in the markets now, I wouldn’t worry about it. But it is a slightly different picture of China in terms of the longer term perspective, if you think that this is not just getting through a rough patch, but that we are keeping the growth rate up through interventions, which can be sustained for a long time.

The other concern is, some of these interventions cut against the reforms in the economy that this leadership came to power a couple of years ago pledging to take and that many people have been urging for a long time. Now there’s a real “cart before the horse” and “chicken and egg” problem here in that one of the reasons we see this kind of volatility in the stock market is people don’t know quite how to value companies. There’s a lot of poor transparency. The infrastructure of rating systems, investment funds, hedge funds [and so forth] just isn’t there.

So, what are you buying? You’re making a lot of guesses. You add to that that a lot of the shares. Some of them are owned by rich people, [and] some of them are owned by institutions. But a lot of the volatility comes from relatively small-bore people who are taking their savings and are putting $50,000, $60,000 [or] $70,000 into the market. Those, of course, are often the people who rush in after things have already run up. They’re the ones who are getting hit now.

Given all of that, the good news is the linkage between what happens in the stock market and the real economy is not necessarily super tight. It’s not a logical connection, given the relative size of the stock market to the economy, and given the ways in which share values don’t tell you all that much.

“People on The Street are probably concerned about China mostly because they look around the world and there are not a lot of positive signs of growth anywhere except initiatives coming from China. And so, the worry is that if China is struggling, then what does that mean for the rest of the world?” –Ann Lee

But you do worry about what the reaction is all the way down the road. It’s far from [the] time to panic. You could wipe out Greece several times over and not put a dent in the Chinese economy. I’m by no means being doom-and-gloom here. I just think that what we are seeing here are signs of not imminent catastrophe, but signs of concerns and cracks.

The real issue is going to be, if they get through and when they get through -, and they will– the immediate stock market fall, what does this mean for some of the reforms on the agenda that actually cut the other way from the kind of state interventions we’re talking about?

Knowledge@Wharton: Will we have this conversation, if we don’t have the crisis in Greece going on right now? A lot of these things that are happening in China were bound to happen.

DeLisle: Yes, the world’s a pretty skittish place on economic issues right now. When China was doing 10%-12% growth, the stock market went up [and] down — who really cared? But the concern that anything can upset the apple cart a little bit is heightened now. The world looks at China after the Greece [crisis]. They’re both economic problems. But the links between them are not terribly profound. It’s just a general sense of fragility.

Knowledge@Wharton: Ann? It does seem that there isn’t much of a link whatsoever between the two, even though there are concerns on both sides.

Lee: Sure. People on The Street are probably concerned about China mostly because they look around the world and there are not a lot of positive signs of growth anywhere except initiatives coming from China. And so, the worry is that if China is struggling, then what does that mean for the rest of the world, since China is the largest trading nation in the world, and so many nations depend on China’s leadership in that area to continue growing? When people hear that Greece might create havoc with the EU (European Union) … then what’s left would be Asia Pacific. So this is scary to some folks, if they don’t quite understand what’s really going on in China. Yes, this could cause a pause, but certainly not something that should be a serious concern overall.

Knowledge@Wharton: In terms of what the Chinese government will need to do or want to do, it’s important now to get it done now, but it’s going to play out over several months and couple of years.

DeLisle: There is an immediate term and a somewhat longer term. The question is: Will they be successful in stopping the bleeding? There are a bunch of interventions [and it seems] like they’re probably going to do that. We saw the big 25% fall, then a little bit of a bounce, and then a fall again. But if you look at the trend lines over the last month or so, there’s a real steep part that seems to have, at least for now, ended. And, as Ann was saying, this is a regime that’s committed to fixing that problem. And that can be handled.

When everybody catches their breath, the question is: What goes on in the broader realm of economic policy, which has an impact on the markets? And what goes on in terms of the reforms that would be necessary to have the markets be somewhat less volatile? The Chinese stock markets are way more volatile than anything in the economy really justifies.

This is, for all the reasons we’ve been talking about, something that goes up and down in a way the economy just doesn’t. So we also may see a period, as has happened before in Chinese stock market; historically, it has been quite volatile. But there have been periods of high volatility and relatively low volatility. When you get a big slaughter like this where it makes the headlines, sometimes people get a little more wary of getting into the market.

In the early ’90s, the story was, “Oh, the stock market will never go down, it will always go up.” And, everybody plowed in. And there were, of course, corrections. And it seemed to settle down for a bit. Now you hear at least the anecdotes on the streets, [and] everybody is just piling onto it because it’s a great way to make quick money.

Although, now, you get more of the story that says, “Where else am I going to put my money?” As Ann was saying, there are not a lot of other options. Real estate doesn’t look so good anymore. It’s not the boom market that it was.

There are capital controls on sending [money] outside. How many consumer goods can you buy? I mean, what are you going to do with the money? That’s really the thing that underlies what you see as a lot of speculative activity in the market.

Knowledge@Wharton: What do you see, Ann, then, in the near term with investors and their view of China going forward? Is it going to be, even with the markets dropping, a spot where people will look for those right areas where they can see growth in the near future?

Lee: Yes. A lot of sophisticated investors recognize that China’s markets are still rather embryonic. There are going to be growth pains here as the regulators try to figure out how to best regulate it and try to liberalize it without it causing harm to the greater economy. As this regime tries liberalize [the stock markets], it is going to make some mistakes along the way. There [will] be course corrections. I don’t think that this [will] have a lasting effect on the financial sector overall, … because they’ve been trying to do it slowly and piecemeal in liberalizing it.

A lot of folks on Wall Street are still going to see this as the last great gold rush for them. They’re not going to step away from China’s financial markets forever. This is something that everyone is still dying to get in, but they’re waiting to see what the government’s going to do next, and just be patient with it. People have already been patient for years with this. A few more years is probably not going to make a big difference.

 

 

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