NEW
YORK – The problems with China’s economic-growth pattern have become
well known in recent years, with the Chinese stock-market’s recent
free-fall bringing them into sharper focus. But discussions of the
Chinese economy’s imbalances and vulnerabilities tend to neglect some of
the more positive elements of its structural evolution, particularly
the government’s track record of prompt corrective intervention, and the
substantial state balance sheet that can be deployed, if necessary.
In
this regard, however, the stock-market bubble that developed in the
first half of the year should be viewed as an exception. Not only did
Chinese regulators enable the bubble’s growth by allowing retail
investors – many of them newcomers to the market – to engage in margin
trading (using borrowed money); the policy response to the market
correction that began in late June has also been highly problematic.
Given
past experiences with such bubbles, these policy mistakes are puzzling.
I was in Beijing in the fall of 2007, when the Shanghai Composite Index
skyrocketed to almost 6,000 (the recent peak was just over 5,000),
owing partly to the participation of relatively inexperienced retail
investors.
At
the time, I thought that the greatest policy concern would be the
burgeoning current-account surplus of over 10% of GDP, which would
create friction with China’s trading partners. But the country’s leaders
were far more concerned about the social consequences of the
stock-market correction that soon followed. Although social unrest did
not emerge, a prolonged period of moribund equity prices did, even as
the economy continued to grow rapidly.
In
2008, it was a combination of exploding asset prices and excessive
household-sector leverage that fueled the global financial crisis. When
such a debt-fueled bubble bursts, its effects are transmitted directly
to the real economy via household-sector balance sheets, with the
reduction in consumption contributing to a decline in employment and
private investment. It is much harder to find circuit breakers for this
dynamic than for, say, that caused by balance-sheet distress in the
financial sector.
Yet
the Chinese authorities seem not to have learned the lessons of either
episode. Not only did they fail to mitigate the risks, underscored in
the 2007 collapse, that new retail investors introduce into the market;
they actually exacerbated them, by allowing, and even encouraging, those
investors to accumulate leverage through margin buying.
Making
matters worse, when the current stock-market correction began in early
June, Chinese regulators relaxed margin-buying restrictions, while
encouraging state-owned enterprises and asset managers to purchase more
stocks. The authorities, it seems, were more interested in propping up
the market than allowing for a controlled price correction.
To
be sure, China’s stock-market bubble did not emerge until recently.
Last October, when the Shanghai Composite Index was in the 2,500 range,
many analysts considered equity prices undervalued. Given relatively
strong economic growth, rising prices seemed justified until about
March, when the market, driven by mostly thinly traded small- and
mid-cap stocks, shot to over 5,000, placing the economy at risk. (And,
in fact, many still claimed that the rally was not unsustainable, as the
stock market was trading at a forward price-to-earnings ratio of about
15, consistent with its ten-year average, in mid-April.)
image: https://www.project-syndicate.org/flowli/image/spence73-chart/original/english
But
it was a bubble – and a highly leveraged one at that. While periodic
bubbles may be unavoidable, and no bubble is without consequences, a
highly leveraged bubble tends to cause far more damage, owing to its
impact on the real economy and the duration of the deleveraging process.
This
is reflected in the persistently sluggish recovery in the advanced
economies today. Even the United States, which has fared better than
most since the crisis, has recorded GDP growth of little more than 10%
since the start of 2008; over the same period, China’s economy grew by
about 66%.
Of
course, with China’s household sector holding a relatively small share
of equities compared to real estate, the current stock-market slump is
unlikely to derail the economy. Nonetheless, as in 2007, the prospect
that lost savings will trigger social unrest cannot be dismissed,
especially at a time when tools like social media enable citizens easily
to share information, air grievances, and mobilize protest.
As
previous crises have shown, and as the current downturn in China has
highlighted, steps must be taken to mitigate market risks. Specifically,
China needs prudential regulation that limits the use of leverage for
asset purchases. Here, the country already has an advantage: relatively
high levels of equity and low mortgage-to-value ratios typically
characterize real-estate purchases by China’s household sector.
Moreover,
once a market correction begins, the authorities should allow it to run
its course, rather than prop up prices with additional leverage – an
approach that only prolongs the correction. If Chinese regulators allow
the market to correct, sophisticated institutional investors with a
long-term value orientation will ultimately step in, enhancing the
market’s stability. In the interim, the use of public balance sheets to
purchase enough equity to prevent the market from over-correcting may be
justified.
As
China’s markets expand – the capitalization of the Shanghai and
Shenzhen markets is on the order of $11 trillion – they are increasingly
outstripping policymakers’ capacity to manage prices and valuations.
The only practical way forward is for the Chinese authorities to focus
on regulatory and institutional development, while following through on
their commitment to allow markets to play the decisive role in
allocating resources.
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