photo:Max-Leonhard von Schaper
Most things in China are unfamiliar to foreigners, even its stock market. This is the final part of a three part series on the Chinese stock market crash.
The fall in Chinese stock prices is unlikely to have any immediate effect of other equity markets directly. The effects on China’s economic activity are the primary concern. These, in turn, may flow through into the global economy, affecting growth, trade, commodity prices, inflation and capital flows.
The impact on the real economy has been muted to date. The paper profits of inflated share prices did not have a major effect on consumption. It is incorrect to assume, however, that the fall will have no effects. To the extent that wealth losses have occurred and uncertainty has risen, Chinese households may increase already high saving rates reducing consumption and slowing growth. The output of the finance industry contributed around 16% of GDP in the first quarter of 2015. It accounted for 1.3% of China’s 7% growth in the same period, compared to a contribution of about 0.7% to the 7.4 percent growth in 2014. The slowdown will affect growth in future periods.
The financial effects may be greater. The consensus view is that margin loans are modest relative to the size of the banks (around 1.5% of total banking assets) and the economy, implying the risk of a major financial crisis is limited. But there are reasons for caution.
First, the amounts involved may be much larger than expected. The amount of official margin debt extended by securities companies of US$250-300 billion may only be a fraction of the real level of stock secured debt. Once vehicles like umbrella trusts, private lending arrangements etc. are included the amount may be 50-100% higher.
Second, the exposure of the banks is greater than commonly assumed. Around 60-70% of all lending in China is from banks. While precluded from direct exposure to stocks, banks have significant exposure to securities companies, broking firms, investment funds and trust companies which provide margin financing. Banks also finance listed companies where the collateral securing the loan is stocks. General purpose bank loans to household and companies may have been used to buy stocks. Problems may emerge over time.
Third, the official permitted level of leverage is a modest 2 times or loans totalling 50% of the value of the stocks. In reality, real leverage was higher, at least double the leverage to 4 times or loans totalling 25% of the value of the stocks. In addition, there were multiple layers of leverage. Investors would borrow funds from bank using the borrowed funds as the capital to purchase shares on margin.
The financial exposures derive from an essential circularity in the engineering of the stock boom. The intention was to use higher stock prices to allow heavily indebted entities to raise equity to pay back otherwise unsustainable borrowing, in effect reducing the risk of loss of banks. Instead, the banks were lending money directly or indirectly to investors to buy shares where the proceeds may have been used to pay back the bank. In reality, the banks had just exchanged risks without necessarily reducing the risk of loss. The circularity has been compounded further after the share market falls. China’s biggest state-owned banks, under government encouragement, have lent over US$200 billion to the country’s margin finance agency to support share prices.
The real damage is subtler bringing into question the fundamental economic model, the reform agenda and the political authority of its leadership. Instead of diverting attention from existing challenges, the stock market correction has drawn attention to challenges such as the end of property boom and other challenges.
Chinese real estate represents around 23% of GDP, about three times that of the US at the height of its property bubble. Prices appear inflated relative to incomes and rental yields.
Despite vacancy rates of over 20% and inventories equivalent to 5 years demand in some cities, new housing starts are around 12% above sales. In China, investment spending as a percentage of GDP is unprecedented in history, creating massive overcapacity.
The accompanying credit bubble remains an immediate concern. By 2014, total Chinese debt was US$28 trillion (282 percent of GDP), higher than comparable levels in the US, Canada, Germany and Australia. In comparison, China’s debt was US$7 trillion (158 percent of GDP) in 2007 and US$2 trillion (121 percent of GDP) in 2000. This increase in its debt of by more than US$20 trillion since 2007 is, approximately one-third of the total rise in global debt over the period. The problem is compounded by the use of this debt to finance assets with inadequate returns to meet interest and principal repayments.
While in isolation a significant but perhaps manageable problem, the stock market falls especially if the Chinese authorities are unable to bring it under control will ultimately affect China’s potential growth which has, since 2009, contributed significantly to global economic activity. This concern is reflected in significant falls in global resources stocks, as investors anticipate a slowing demand for commodities.
The episode may slow down or defer necessary economic reforms. The fear is that China’s proposals are rhetoric, primarily for foreign consumption. At the 2013 Third Plenum, the Communist Party stated that market forces must play a “decisive role” in allocating resources. The stock market crash and the response suggests that the Chinese authorities are likely to resort to tried and tested command and control measures when events develop in an unwanted way, relying more on Communist dogma than market forces.
The stock market crash has drawn attention to the underlying repressive economic processes. China’s financial system is predicated on directing savings of ordinary Chinese into areas for policy purposes, especially maintaining economic growth. The regime relies on keeping the cost of funds artificially low usually below inflation rates. The system allows Communist Party connected firms and privileged insiders to benefit.
The stock market boom allowed elites to access cash from Chinese savers. The first group who benefitted were those who were able to list or sell shares to take advantage of artificially high prices. The second group were those who gained preferential access to shares in hot listings or benefitted from private information about earnings and corporate actions.
The fall in prices affects both groups. The financial elite are deprived of easy money making options, especially as other sources of profits such as property are unavailable. Ordinary savers encouraged by the government to invest in stocks face large losses, increasing resentment at the nature of the game and growing wealth gap.
In April 2015, when the Shanghai stock index rose above 4,000, the Chinese Communist Party through its media organs trumpeted the new “Chinese Dream”, an essential part of which was increasing prosperity from rising share prices. That dream may yet turn into a nightmare for China, its investors and especially its leaders.