Making sense of a wild ride for the Chinese economy
On Friday, China was awarded the 2022 Winter Olympics, which will make it the first country with a city, Beijing, to host both Summer and Winter Games. But that wasn't the big news out of China in the past week. A huge slide in the Chinese stock market on Monday and Tuesday brought the July decline in the Shanghai Composite to nearly 15 percent. It's down by twice that much going back to mid-June. Roughly $4 trillion in market value has been wiped out.
At this point in China's stock-market spiral, it's too soon to really know how big a deal it is.
The basic point that everyone agrees on: China's growth is slowing. The most recent reports put GDP growth at a 7 percent annual rate, well below the 8 percent to 14 percent rate China has sustained for more than 20 years.
But there's lots more in dispute.
Foreign investors are avoiding China. The country's equity exchange-traded funds suffered outflows on 14 of 17 trading days in July, totaling $1.1 billion, or 5.9 percent of assets, research firm TrimTrabs said in a statement on Tuesday.
There are good reasons to fret about what happens next in China, as well as rational economic arguments to make that a looming Chinese bear market will at worst resemble the 2000–2002 U.S. tech bust—which caused only a mild recession—rather than anything like an Asian version of the 2008 financial collapse. To help make sense of the wild ride in China that has world markets on edge, consider the following nine debate points:
1. Chinese stocks are not the Chinese economy.
Chinese companies don't usually use the stock market to finance their growth. According to economic-consulting firm IHS Global Insight, only 5 percent of China's private investment is financed by the stock market—down from 25 percent in 2007. The rest comes from bank lending, and Chinese authorities have made clear that they will make sure the banks have money to keep lending.
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Movements in China's stock market, housing market and corporate profits have had little correlation. And even though the Chinese market is heavily influenced by very active retail investors, only 15 percent of Chinese households own stocks and only 6 percent of household assets are in stocks, so consumption should be little affected, IHS stated.
2. Valuations for most companies, while high, are not nuts.
Before June, the average Shanghai exchange stock traded at a price about 40 times higher than companies' profits, down from 70 before a bust in 2007. That was already down to about 27 by early July, according to a Merrill Lynch calculation, and while those numbers are higher than in the U.S., the U.S. economy's growth rate is less than half of China's recent 7 percent annual clip.
3. Chinese bonds are holding up fine.
Chinese 10-year bonds are yielding less than 3.5 percent interest per year, not as low as bonds from slower-growing European or North American nations, but nothing suggesting investor panic. In fact, Chinese bond yields have fallen through most of 2014 and 2015, according to Trading Economics. Other interest-rate measures like bond spreads have also stayed stable.
4. The government is on the case, and that's pushing money into the market.
The Chinese government borrows in its own currency, unlike Greece for one, and that gives authorities the flexibility to push as much money into their financial system as it takes to keep any contagion from forming. Beijing has also been quick to encourage Chinese institutions to put money into the market, which has until this week had reversed institutional fund flows out of mainland stocks. And officials are threatening to crack down on short selling, in a bid to make bearish investors less influential and effective.
5. Bear markets in China are nothing new.
In fact, Chinese stocks spend most of their time in a bear market.
The Shanghai Composite Index has experienced 10 bear markets in the last 25 years for a total of 188 months, according to Tom Lee of Fundstrat Global Advisors. That means China was in a bear market more than 60 percent of the time.
So big swings in stocks are nothing new to China and, in the past, have not caused a collapse in U.S. stocks or the global markets.
On the other hand ...
6. Chinese tech-stock valuations are high—really, really high.
By some measures, Chinese stocks (especially in tech) are more overvalued than U.S. tech stocks were in 2000. Bloomberg reported as far back as April that Chinese technology stocks were trading at 220 times their reported profits, the highest in the world. That even crushed the 156 price-to-earnings ratio sported by U.S. tech stocks in March 2000, right before the bubble burst.
7. China has a ton of debt, and other asset bubbles.
China's debts are anywhere between 175 percent and 225 percent of its annual gross domestic product, Mesirow Financial chief economist Diane Swonk said. As an example, she noted that Thailand had debts of 180 percent of GDP before its late-'90s financial crisis. In Swonk's opinion, the worst-case scenario is that China's economy goes through a long process of repricing leveraged assets a la Japan.
Meanwhile, housing prices in China have dropped nearly everywhere in the last year, further threatening the finances of retail investors. Real estate is one reason noted short seller Jim Chanos has been bearish on China for years, along with the debt load he says could reach four times GDP.
8. Individual investors are huge in China's market.
Some reports estimate that individuals drive as much as 85 percent of stock trading in Shanghai. But underlying that action, the stock market mess has been fueled partly by the unraveling of margin debt and the crimping of margin lending. Merrill Lynch has pointed out that only a small percentage of the margin debt was extended between April, when the Shanghai market topped 4,000 for the first time, and when it hit its peak of 5,178.19 in June. Some traders blamed this past week's sharp drop on a sudden reduction of margin-loan availability, and at least some investors are due for margin calls by now.
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Margin lending has been a significant driver boosting Chinese shares, helping the Shanghai Composite clinch repeated seven-year highs earlier this year. Will Oswald, global head of fixed income, currencies and commodities research at Standard Chartered, told CNBC. "When you've got that type of leverage built up through margin accounts, it's a lot harder to stem the correction, but China is working on balancing between the moral hazard risks of supporting the market versus dislocated prices," Oswald told CNBC earlier this week.
Trading volumes in Shanghai have halved from their peaks in June, while margin debt, which had fueled a world-beating rally for China's stocks, declined to a four-month low, according to Bloomberg.
9. Lack of transparency hurts confidence.
China's "rescue squad," as it's called, went into action this past week. The China Securities Regulatory Commission said late Monday that the local government would increase purchases of stocks, while the central bank injected cash into money markets and hinted at further monetary easing. On late Tuesday the country's securities regulator said it was investigating share-dumping incidents that occurred Monday.
"Call it what you will; the aptly named 'rescue squad' have made their intentions clear and will continue to support the Chinese markets at any cost. The strength is seen in the 200-day moving average, and further investigations into Monday's price plunge will limit major downswings for the next few weeks," IG's market strategist Evan Lucas wrote to investors on Monday.
That stabilized Chinese stocks in the second half of the week. But volatility has been the norm for Chinese stocks in the past month. In early July, when the and restricted short-selling, the Shanghai Composite rose by as much as it went down this past Monday—8 percent
There's a flip side to the Chinese government's intense support of the market—no one really knows how bad the underlying problem is. At times, more than half of stocks in Shanghai have been suspended from trading. One reason for this past Monday's drop was speculation that the government would stop propping up shares, Moody's Analytics argued. Traders are saying they don't know the correct price for different shares, because of all the intervention, and wonder what the government's actions may be hiding from view.
—By Tim Mullaney, special to CNBC.com