China's troubled economy: 11 things you need to know
Updated by Ezra Klein on July 9, 2015, 12:10 p.m. ET @ezraklein
1) China's stock market has lost a third of its value over the last month
On Wednesday, the benchmark Shanghai Composite index fell another 5.9 percent, bringing the market's total losses to 32 percent in less than a month. That's ... big. And it's big in part because China's economy is so big. This tweet from Zero Hedge gives a useful sense of scale:
China has lost 15 Greeces in market cap in three weeks
11:55 AM - 8 Jul 2015
China's stock market rebounded a bit on Thursday, but given the amount of support the Chinese government is providing, the fact that a majority of companies have halted trading, and the number of regulations meant to stop further sales of stock, it's hard to say whether that represents real gains or artificial supports.
2) China's stock market boom is built on debt
Investing borrowed money used to be heavily restricted in China, but the authorities have loosened the regulations since 2010. The result has been an explosion of debt-fueled trading.
"By official count, margin debt on the Chinese stock market has tripled since June 2014," wrote Ruchir Sharma, head of emerging markets and global macro at Morgan Stanley Investment Management, in the Wall Street Journal. "As a share of tradable stocks, margin debt is now nearly 9%, the highest in any market in history."
And it's not just margin debt. People have been finding creative ways to evade the regulations the Chinese government left on the books (as detailed in a helpful May report from Credit Suisse). So there's yet more risky debt, and yet more risky trades, than that chart suggests.
3) Most of China's new investors don't even have a high school education
"Unlike other major stock markets, which are dominated by professional money managers, retail investors account for around 85 percent of China trade," reports Reuters.
Or consider this data point: "A majority of the new investors in China’s market don’t have a high school education (6% are illiterate)." There are now more retail investors in the Chinese stock market (90 million) then there are members of China's Communist Party (88 million).
There's an optimistic spin to put on this: Individual borrowers don't create systemic risks. A bunch of farmers going bankrupt doesn't imperil the global financial system.
But there's a pessimistic read, too: These borrowers — and there are a lot of them — got into the stock market because the Communist Party, in word and deed, was pushing them into the stock market. Then the market crashed. They will be justified in partially blaming the government for their losses, and the Communist Party has never been particularly good at dealing with widespread anger at the regime. In that way, even if the economics of individual borrowers are simpler, the politics can be much worse.
"This is a real testing moment for the leadership," Zhao Xijun, deputy dean of Renmin University’s School of Finance, told Bloomberg. "The evaporation of fortunes of more than 80 million individual investors would pose unthinkable social problems for the country."
4) The Chinese government tried, and failed, to stop the crash
The list of interventions Beijing has mounted is long. The government helped kick off the stock market boom by loosening regulations on borrowing, cutting interest rates and bank-reserve requirements, and filling the state-run media with stock-market boosterism.
Then, as the market began dropping, the country's leaders unleashed a ferocious set of interventions to stop the fall. As the Economist writes, the government has put on "a spectacle of ever-more drastic actions to save the market. Regulators capped short selling. Pension funds pledged to buy more stocks. The government suspended initial public offerings, limiting the supply of shares to drive up the prices of those already listed. Brokers created a fund to buy shares, backed by central-bank cash. All the while, state media played cheerleader." My favorite bit of media cheerleading: "Rainbows always appear after rains," promised The People's Daily.
This apparent fecklessness has rattled markets yet more. "Beijing’s inability to stop the recent decline has rattled investors who have long been used to seeing the government use its power to control markets," reports the Wall Street Journal.
5) China's stock market is big — but it's not that big
As the Economist notes, "Lost in all the drama about the stock market is that it still plays a surprisingly small role in China. The free-float value of Chinese markets—the amount available for trading—is just about a third of GDP, compared with more than 100% in developed economies. Less than 15% of household financial assets are invested in the stock market: which is why soaring shares did little to boost consumption and crashing prices will do little to hurt it."
You might think, given that, that the Chinese government wouldn't much worry over the gyrations of the stock market — after all, it's still up 80 percent from last year. But the stock market's crash comes on the back of broader woes in the Chinese economy. Growth has been slowing for years, and economists broadly agree that the country's export-driven economic model needs a (possibly painful) overhaul.
In this, the stock market is as much symbol as anything. The Chinese government is good at hiding the country's economic problems from outside eyes, but it can't hide a plunging stock market. Given that, officials have tried to intervene directly to stop the market from plunging, and that just made them look weak and has focused more attention on the Chinese economy's problems.
6) The deeper problem: China's export-based model has stopped working
China's stunning economic rise has been fueled by low-cost exports. But as its economy has grown, the export model has begun to crack apart.
"It has outgrown the export-led growth model that led it to rely on external demand and high internal investment," says Patrick Chovanec, a longtime China watcher who is currently chief strategist at Silvercrest Asset Management. "So now it needs to shift to a model that is more balanced between investment and consumption."
Around the 2008 recession, in particular, global demand fell, and China couldn't keep its growth going through exports. And its own citizens weren't consuming enough to create the demand necessary to keep the growth engine revving.
The Chinese government's answer was to use monetary policy, state-owned banks, local governments, and other tools under its control to push internal investment. The result was a massive buildup in factories, highways, airports, real estate, and much more. Some of these investments were wise. Many weren't. China has become famous for its profusion of empty stadiums, skyscrapers, and even cities. The result, says Chovanec, is "a lot of overcapacity and bad debt."
This is part of why the Chinese government encouraged the stock market boom, Sharma said in an interview. "The Chinese government basically comes up with this plan. They see they have these heavily indebted companies that need to raise money to clean up their balance sheets. They realize there are these huge savings in China that can be put into the stock market. So they begin talking up the stock market and they make it easier to use margin debt. And margin debt exploded."
So the stock market crash speaks to a much larger problem: China has not transitioned to the kind of consumption-driven economy that it needs to have. It is stuck in an outdated economic model that is unsustainable.
7) China's growth is slowing — and that scares the Communist Party
China's official inflation-adjusted growth rate in 2014 was 7.4 percent, and the economy grew by 7 percent in the first quarter of 2015.
Sound pretty good? Not for China. It's almost an article of faith among senior leaders in the Chinese government that 7 percent growth is the bare minimum needed to keep the society stable. In the Communist Party's view, this is the basic bargain they have made with the citizens of China: The people give them power, and they give the people growth. If they stop giving the people growth, well, the people might stop giving them power — and no one knows what happens in that scenario.
Here's the other problem: That 7 percent number might be bunk. Some Chinese officials have privately admitted that the official GDP statistics are unreliable. "The headline number of 7 percent in China is not something that’s corroborated by other data, like electricity production or import growth," Sharma says. "That data paints a picture of an economy growing at more like 5 percent."
But even if the official data is right, it's still a 25-year low for the country. And that's part of why the Communist Party is so desperate to get growth back on track.
8) China's leaders have less power to direct the economy than many think
So why hasn't China made this transition to a new, healthier kind of economy? Why is it stuck in an unsustainable model? One reason is that its leadership, though it may appear monolithic and all-powerful from the outside, actually isn't.
One place you can see this play out is in steel production. China has long produced and exported way too much steel, flooding global markets and keeping China's economy on the export-led model it needs to drop. So, just about every year, China's leadership comes out and announces that it's going to cut steel production. And, every year, steel production does the opposite: It goes up. It only finally dipped for the first time in 20 years this spring, after US and EU producers called for tariffs to punish Chinese overproduction.
Beijing can make all the declarations it likes, but there are a lot of high- and mid-level officials, not to mention the powerful state-run industries, that might not see it as in their interest to go along. Those officials are really invested in the status quo — often quite literally so, with corruption rampant.
This gets to the larger problem with China's needed economic transition to a consumer economy: The leadership can't pull it off unless the larger Chinese system wants to make it happen, which is very hard for the simple reason that it would be bad for the people who dominate that system.
9) China's government is terrified of economic problems leading to social unrest
The countercurrent here is that the Chinese Communist Party is deeply paranoid. It fears that economic crisis could lead to social unrest, and that social unrest could lead to utter catastrophe. That was a chief lesson it took from the 1989 Tiananmen Square protests, which were spurred in part by economic problems, and which Beijing saw as so dangerous it deployed tanks into the streets.
China's leaders are willing to go to extraordinary lengths to prevent that from happening again, which in economic terms means keeping growth up. This makes them at times very risk-willing; the stakes, in their minds, justify it. At the same, their fear of the consequences of disaster can make them risk-averse and conservative.
You can see these dual impulses play out, for example, in the leadership's handling of the stock crash. Chinese leader Xi Jinping had promised since 2013 to let market forces play a larger role in the economy, but over the past week has gone back on that, intervening heavily to prevent a bigger crash.
10. China's leadership has managed to resolve economic crises in the past
One reason there is tremendous debate among China watchers over the health of China's economy is that on the one hand, there are many indicators that the system is fundamentally unhealthy, but on the other, the leadership has shown time and again that it can resolve the crises these problems create. The current stock market crash is just the latest in a very long series of economic and political crises that have hit the country: the 2011 Wukan village protests, for example, or the 2013 credit crunch.
Every time, it looked like a crisis that got right to the heart of China's fundamental weaknesses and could perhaps bring the system tumbling down. Every time, the leadership managed to pull through and to keep the system in place; within a couple of weeks or months, the supposedly existential crisis was over, and things were more or less back to normal. The result has been growing market trust in China's government, as the pessimists who keep predicting collapse keep being proven wrong.
Of course, past performance is no guarantee of future results.
11) It's dangerous for the world to lose faith in China's government
Financial crises happen when markets have to reevaluate an important investment premise all at once. In 2007, for instance, markets were forced to abandon the idea that subprime loans were low-risk. In 2010, they were forced to abandon the idea that loans made to eurozone members like Greece were safe. The biggest danger here is that a series of bad decisions by the Communist Party will force the world to reevaluate a truly critical investment premise: that China's government knows what it's doing.
"People are seeing now that the Chinese economy might now be too large and too complex for the government to be in control of it, and that would lead to a fundamental reassessment of the risk for China," says Sharma.
China's stock market isn't that big, and because of regulations sharply limiting foreign investment, it isn't that integrated into the world economy. So the consequences of a stock market crash aren't that severe. But China is huge and fully integrated into the world economy. The consequences of political unrest in China, or a true crisis in its economy, could be very real, not least of all for the Chinese people.
Additional reporting by Timothy Lee and Max Fisher.
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