In June 2015, Chinese stockholders thought the world was falling apart. More than half the companies listed on the Shanghai Stock Exchange halted trading as the market crashed by nearly 30%. With the sell-off deepening every day, Chinese officials were forced to intervene in the market using a “first aid” strategy. They became paramedics for the market, patching up wounds without actually restoring the patient to full health. The result: a full-blown economic collapse that could tip the world into another recession. (Source: Vox, July 8, 2015.)
This is no joke; the global economy is truly at risk. China became the engine of global growth after the 2008 financial crisis, usurping a position long held by the United States. This monumental shift in leadership seemed natural given China’s miraculous growth story. The country tripled its national output since the dawn of the new millennium, and it makes investments into strategic assets like energy, precious metals, and farmland. Not to mention, its leaders have repeatedly made overtures to international markets, trying to secure the yuan as a reserve currency for the world.
But the shift has also made us vulnerable to a downturn in China’s economic performance. And I’m sorry to say, but we overestimated China’s leadership.
Taking on a larger role in geopolitics means having to abide by the same rules as everybody else, a concept China is unused to. State capitalism has worked magnificently for the country’s controlled expansion. Its state-owned companies went abroad to compete in market-based economies, while the country’s internal workings remained opaque. But as China’s influence grows, outside stakeholders are demanding greater transparency. The level of scrutiny has elevated, and there are major questions about China that need answering. For instance, in response to China’s bid for reserve currency status, investors are saying: OK, now show us your gold reserves.
Warning: Chinese Stock Market Crash Signals Global Recession
The pressure on China to integrate into a global financial system is mounting, with disastrous implications on the horizon. But China just sent a major signal to the world that they follow their own schedule. Before I get to that, let’s take a step back. What caused the stock market boom in the first place?
On a micro level, the rally began in mid-2014 when financial regulators allowed margin trading on the Shanghai Stock Exchange. Margin trading is effectively borrowing money for stock purchases, a way for investors to leverage up their bets and multiply their earnings. The government imposed a 2:1 ratio, meaning if you opened a margin trading account with a $4,000 balance, you could now invest $8,000.
It’s important to remember that leverage can also run investors into negative territory. You now only have 50 cents for every dollar you’re risking, and that can be a precarious scenario. If the value of the investment collapses, you could lose more than just the principal amount. You could actually owe money.
Unsurprisingly, the burst of credit fueled a 150% stock market boom between 2014 and 2015. In January of this year, regulators started worrying about the rampant speculation, but they were unsuccessful at reigning in leverage. Eventually, the margin trading policy was reversed. That was June 12th—day one of the epic decline. The causation is shockingly transparent here; a bubble was built on credit and the fall came from that credit being taken away.
While these actions seem short-sighted in the extreme, they make more sense when you look at the macro hurdles facing the Chinese government. The country is caught between a rock and a hard place, and they’re simply doing what’s right for their citizens. China’s economy may be the second-largest in the world, but its living standards haven’t caught up with that fact. The country is at risk of falling into what’s known as the “middle income trap.”
China’s Economy Slows While Consumption Remains Muted
The middle income trap is a common issue for developing nations. At first, a low-income country can experience explosive growth on the back of capital inflows and rapid increases in output. But sooner or later, things have to change. There’s only so long that China could be the world’s factory before its labor force starts demanding a better quality of life. The resulting wage growth will eat away at China’s competitive advantage in manufacturing, but it is both a humanitarian and political necessity.
At present, the average income in China is $7,594—putting it in the upper-middle income bracket. The World Bank classifications show that upper-middle income means a per capita income between $7,250 and $11,750, meaning China still has a ways to go before it can successfully break into the high-income category. (Source: Levy Institute, April 2012.)
No one wants a Chinese economic collapse. If the country’s growth trajectory flatlines, markets will simply run out of oxygen. China’s emerging market suppliers will suffer from the loss of demand, investors will drain capital out of the market, and pessimism will take root. This is the apocalyptic scenario that Chinese officials are trying to avoid.
However, breaking into the high-income category requires a fundamental reorganizing of China’s economic structure. To put it bluntly, people need to buy more stuff. Consumption is the key to avoiding a middle income trap, because the better lifestyles afforded to citizens usually cycle back into the economy with increased spending. It’s an intrinsic component of developed nations, despite having several downsides. If the transition to higher consumption isn’t matched with increases in productivity or innovation, the country can lose its competitive advantage. The world economy can’t afford that right now.
That’s why China is pulling out any and all stops to save its economy.
China Borrows from the Federal Reserve Playbook
Now that we have proper context for China’s stock market crash, let’s look at the aftermath. The government implemented several policies to mitigate the crisis, including: a ban on short selling, a ban on large shareholders from dumping their positions, and printing money for asset purchases. A lot of attention has been paid towards the first two policies, but they were temporary responses. My main interest is in the final measure the government adopted: printing money for asset purchases.
State-owned banks starting buying shares of companies whose value was plummeting on the stock exchange. Simultaneously, the required reserve ratios for banks have been cut multiple times. That means the government is allowing Chinese banks to slice away at their capital buffer so they can help pump demand into the stock market. The central bank also cut interest rates to promote easier lending conditions in the hope it will stimulate growth.
Let’s recap: low interest rates, higher leverage, and printing money for asset purchases. Are we talking about the Federal Reserve or the PRC? Most media sources are currently bashing the Chinese government while gleefully ignoring the fact that our central bank has been doing the same thing for seven years. (Source: Reuters, August 25, 2015.)
That being said, it’s a doomed strategy. No amount of monetary stimulus can erase fact, and I think China is misguided in following the Federal Reserve playbook. Credit-fueled growth can definitely create a stock market boom in the short term, but it’s disastrous over the long haul.