Stock Market Crash: China Could Spark an Economic Collapse in 2016

China Stock Market CrashAfter a colossal stock market crash in June, many analysts are worrying that China is on the brink of an economic collapse. Panic is setting in as the country experiences a dramatic slowdown in exports and growth. A recession in China would precipitate crises across the world, drawing an eerie parallel to the U.S.-led contraction during the last decade.

After markets collapsed in 2008, we often heard the phrase, “the worst recession since the Great Depression.” First off, that’s a nonsensical statement. “Recession” and “depression” have two separate meanings and you can’t just put them on the same scale. That’s like saying, “I just ate the worst apple since that orange I had last week.”  

But more importantly, why are we still pretending that 2008 was only a recession? Seven years have passed and very few countries can claim a booming economy. No two periods in history are perfectly analogous, but the common definition of a depressionis an extended period of low or negative growth. Sound familiar?

First-quarter growth for the world was 2.2%, far below estimates made by the International Monetary Fund (IMF). And the IMF is constantly making downward revisions to their World Economic Outlook because growth is constantly underwhelming. (Source: International Monetary Fund, last accessed August 20, 2015.)

China’s Stock Market Crash

On June 12, 2015, investors began stampeding out of China’s stock market. The Shanghai Composite Index fell by over 30% in a single month as Chinese officials beat back against excessive leverage in the market. But oddly enough, the officials now condemning the stock market bubble were the ones who made it possible.

Almost exactly one year before the gargantuan sell-off, Chinese regulators allowed what’s known as margin trading, which is basically borrowing to invest in stocks. For example, a regular Joe could take $1,000, open a margin trading account with a bank, and effectively double their investment. This scenario assumes a 2-1 margin ratio, which is precisely the limit China’s government put in place.

Unsurprisingly, we saw a 150% gain in the stock market over the next year. This debt-fueled bubble is becoming a disturbing pattern in China, which also fostered a real estate bubble in the last decade. Part of the problem is China’s relative inexperience with business cycles; they had a controlled economy for so long that market forces seem alien.

One way China tries to counteract the downside of business cycles is debt. Debt as a share of the economy grew 80% between 2008 and 2013. To be sure, China’s borrowing dragged the global economy forward when it was stuck in neutral, but now the country’s debt load is 300% of its output.

The Greater Recession: China’s Middle Income Trap

China accounted for a third of world growth this decade, nearly double the United States’ 17% contribution. For the first time in living memory, the U.S. was replaced as the engine of global growth. China took its place in the wake of the 2008 financial crisis and that’s an unyielding fact. However, the country’s importance on the geopolitical stage has not fully translated into better living standards for its people.

The dichotomy of rapid economic expansion without a corresponding jump in quality of life is common among developing nations. Economists call it the “middle income trap.” Impoverished countries unlock their economic potential through resource exploitation or low-cost manufacturing, resulting in “catch up growth.” Sadly, all good things come to an end.

The only way to escape the middle income trap is higher internal consumption. Typically, people living in low income countries are prone to saving, because leisure spending is an unfamiliar concept to them. Changing this mentality is necessary to China’s future success. Encouraging their citizen to spend more on their own comfort—to take on debt and invest in themselves —is the only way to preventing the global economy from falling into recession.

China has been planning for this shift for a long time, yet they just devalued the yuan, which hurts the purchasing power of Chinese consumers. Exports fell by eight percent in July, and growth is below seven percent. Depreciating currency is standard play to make exports more attractive, however it belies their attempts to boost consumption, a difficult task even in optimal circumstances.

Also Read:

China Stock Market Crash: On the Verge of Economic Collapse

Jim Rickards: China’s Stock Market Crash Isn’t Over Yet

Chinese Stock Market Crash Prediction for 2015