China: How Far Down?

The title, of course, asks an impossible question, at least for mere mortals. A stock market bubble has burst. From its peak last June to their recent lows, Chinese stock prices fell more than 30 percent. Valuations collapsed. Prices at the peak amounted to more than 26 times historic earnings. By mid-July, they stood closer to 19 times.   That movement alone would seem adequate to correct any excesses, especially given China’s growth potentials and the heroic remedial measures to which Beijing has resorted. But busts, like booms, are more emotional than rational in nature. They end only when the panic exhausts itself.

When that time comes, prices should again connect to fundamentals, and these look supportive of an advance, even from today’s levels. Valuations no longer look so stretched as they did, certainly not relative to Chinese growth prospects. No one, of course, expects China’s economy to return to the 10-12 percent annual pace of growth it once maintained, but a 5-7 percent real yearly pace of advance is a reasonable expectation, especially given Beijing’s need to keep producing jobs for an otherwise restive population and the resources at its disposal to secure that growth. There are, as always, significant risks, not the least of which is the slow-motion real estate correction still going on in China. But the probabilities for equities nonetheless favor a return to gains once the present panic runs its course.

The Backdrop

As with so many ugly eventualities, the Chinese stock market bubble began with the best intentions. Beijing promoted stock buying as part of its general efforts to revitalize the economy and reorient it from its heavy dependence on exports toward more domestic sources growth. The reasoning, outlined by Chinese President Xi Jinping, held that a rising, active stock market would encourage the launch of new businesses and draw foreign investment into the country. With that inflow, he looked for a broadening of the economy as well as access to global best practice. He also looked for rising equity prices to help the county’s heavily indebted business sector, allowing it to raise monies through stock offering, repay debt, and create more resilient and dynamic financial structures. Wider ownership of stocks, particularly the issues of state enterprises, President Xi and his colleagues in government argued, would force greater efficiencies and rationalities on these huge firms, promote consolidations in overbuilt industries, and generally re-invigorate what had become a less than dynamic aspect of China’s economy.

For a while, the plan seemed to work well. Interest in the stock market increased. More of the middle class began to buy equities. Prices rose from ten times historic earnings last summer toward a not unreasonable 17 times earnings late in 2014. The business environment did not respond immediately, but then no one expected it to do so. Starting with this new year, however, things began to get out of hand. A large number of individual investors, with no experience in equities and even less advice, began to chase market gains. Significantly, they began to buy on margin, which expanded five-fold during the first half of this year to peak in June equivalent at an of $323 billion. Prices surged well ahead of earnings. The distinct preference for riskier stocks allowed the Shanghai exchange to outperform the larger, more stable Chinese companies listed in Hong Kong and New York. At its peak, the composite index stood more than 150 percent above its levels of last summer. The preference for risk allowed the smaller-stock-oriented Shenzhen exchange to rise even faster.

Though this bubble could have inflated for some time, a bust was inevitable, and it came in June. Not surprisingly, the worst damage occurred among smaller stocks. While prices on the Shanghai exchange fell a bit over 32 percent from their peak to recent lows, prices on the Shenzhen exchange fell more than 40 percent. Meanwhile, the smart money in China seems to have sold out throughout the latter stages of the rally, clearly to those inexperienced, new investors. According to Bank of America Merrill Lynch, major shareholders in Chinese firms sold 360 billion yuan ($58 billion) in equities on balance during the first five months of the year, the most recent period for which data are available, well up from the 190 billion yuan sold during a comparable period in 2014 and 100 billion in prior years. These better informed investors seem to have redeployed their monies to real estate, at least if reports from brokers in such far-flung locals as Sydney, London, and New York are reliable.

The Chinese government has pulled out all the stops to stabilize this situation. The People’s Bank of China (PBOC) has cut rates. Beijing has ordered state-run companies and brokerage operations to buy stocks outright. Officials have stopped all new issuing and have also suspended trading on up to 40 percent of the outstanding listings on China’s two main exchanges. China has even created an entity to hold up demand by facilitating still more margin purchases, some reportedly backed by home mortgages. As of mid-July, these measures had done little to stem the bearish tide. The extraordinary government response may actually have added to the selling pressure by in advertently convincing investors that their panic was justified. From Beijing’s point of view, however, it had little choice. The sudden bust has called the government’s whole economic-fiscal agenda into question. Losses, according to recent reports in both the New York Times and the Wall Street Journal, have brought out atypical criticism of the ruling Chinese Communist Party even among everyday Chinese. That small investors are the biggest losers particularly worries the country’s leadership, for it vividly recalls the social unrest, even rioting that immediately accompanied the recession of 2008. Damage control was essential for political if not financial reasons.

Prospects

Once the current panic plays itself out, market prospects should again connect to the fundamentals: market valuation and growth prospects. Even today’s multiples, at about 19 times historic annual earnings and only slightly pricier than American stocks, could reasonably form a base once the bearish psychology has dissipated. Though the greater risk and volatility in Chinese stocks would seem to demand a lower valuation multiple for them than for American stocks, that economy’s greater potentials for economic and earnings growth could more than compensate. The crucial matter, then, looking beyond the panic, is those growth prospects. They are, to be sure, nowhere near what they were some years ago, when the Chinese economy maintained real growth rates of 10-12 percent a year, and there are risks, as always, but Chinese growth should nonetheless exceed that of the world’s developed economies, including the United States, and so warrant multiples at least at equal levels, despite higher levels of volatility.

Set against this prospect are arguments that the market crash alone will kill the economy, China’s 1929 moment, as some media reports have it. Such bear arguments are weak on several accounts. For one, stock losses to date are actually less severe than in 2008, and that downdraft did not bring down China’s economy[xi]. For another, Chinese managements are generally less sensitive to stock price movements than are their American counterparts, especially in the dominant state-owned firms. At base, stocks in China, and other emerging markets, have less real impact because they are simply less integral to the economy than they are in the United States and other developed econimies. Consider that the value of stocks in China has trended around 50-60 percent of the country’s gross domestic product (GDP), compared with 130 percent in this county. This difference goes a long way to explain the volatility of the Chinese market, and other emerging markets. Small relative to their respective economies, any economic change that increases flows into or out of these markets is bound to have a greater price impact than in more mature financial arrangements. By the same token, movements in relatively smaller, less integrated emerging stock markets have a less direct and profound impact on the respective real economies.

Then, of course, Beijing has tremendous resources with which to counter any ill effects on the economy. The Chinese government has the equivalent of $4.0 trillion in foreign exchange reserves, some 35 percent of GDP, that it could deploy to bolster the economy. More, the Chinese government’s relatively low debt levels give it fiscal options not available to, say, the United States. Though there is a lot of private debt in China, public debt outstanding amounts only to some 25 percent of GDP, compared to Washington’s debt burden of over 100 percent of GDP. These resources could, should Beijing decide it was necessary, enable the government to remount the massive stimulus it used so successfully to counter the effects of the 2008-09 global recession.

China’s command economy also allows Beijing to deploy such a stimulus rapidly, if circumstances demand it. The government may be having trouble stemming the immediate stock market retreat, but the history of 2008-09 shows that such economic stimulus efforts can work to great effect. Indeed, if matters demand it, Beijing would have little choice. It knows that the constant flow of people form the countryside into the cities makes a rapid rate of jobs growth imperative, for social as well as political stability. As already indicated, Beijing learned in the recession of 2008-09 that the country’s lack of a social safety net can lead to trouble on the least interruption in jobs growth. At that time, six, seven years ago, rioting started almost immediately with any layoffs or factory closings. Communist Party officials were attacked, even murdered in the provinces. Beijing had little choice then but to implement that stimulus. The country’s stability and their livelihood, perhaps their lives, depended on it. This pressure may have abated in recent years, but the need to sustain a 5-7 percent real rate of growth persists, and for the same reasons. There can, then, be little doubt that Beijing will do all that it can to sustain this necessary pace of advance.

To be sure, China back in 2008-09 was not facing the slow motion real estate correction it faces today. But the effects of that, though hardly small, are easy to exaggerate, especially among Americans who naturally draw parallels to their own country’s highly destructive real estate problems in 2008-09. Unlike in China today, America’s biggest debt problem was less its size than that the debt was so widespread, so much so, in fact, financial institutions began to distrust each other’s ability to meet their obligations. Financial dealing dried up and the economy suffered accordingly. In China, though the overhang of questionable debt is large, it is far less widespread. Households, for instance, are far from over leveraged, as they were in the United States. Until recently, a Chinese home buyer had to put down 20 percent for his or her first home and 50 percent on a second home. The debt in China is concentrated in local and provincial governments, making it much easier for the authorities to contain and less of a threat to the financial system than was the sub-prime situation Washington faced in 2008-09.

Nor is the chance of a contagion among emerging markets as likely as some of the more panic-struck commentators have suggested. Part of this fear harkens back to the Asian collapse of the late 1990s, the so called “Asian contagion.” But circumstances have changed since then. These other Asian countries have generally improved their finances during the intervening15-20 years, ridding themselves of the fixed exchange rates policies that destroyed their flexibility and the dependence on dollar-denominated debt that so facilitated the transmission of financial losses from one country to another. To be sure, commodity prices and commodity exporters have suffered. Part of this is an old story, a basic reflection of the less intense Chinese demand for such products due to the ongoing change in the nature of that economy and its commensurately slower growth pace. Commodity prices have long since begun to adjust to this development, as have the commodity-exporting economies. The sudden recent commodity price declines, in some cases to levels not seen since the 2009 global recession, reflect an erroneous expectation that the stock price drop will destroy the Chinese economy and so wipe it out. This misses the clear fact that the economy there is not likely to respond as intensely to stock market losses as the bears seem to believe it will.

Though China will never return to the rapid 10-12 percent real annual growth rates of the past, this analysis shows an economy that will likely sustain real growth rates approaching and perhaps exceeding 6 percent. That is more than twice the rate at which the United States is growing. And since corporate earnings should more or less track real growth, there is every reason to expect Chinese stocks, immediate vulnerabilities aside and despite their greater volatility, to sustain multiples somewhere near those prevalent in the United States and other developed markets. If such a conclusion fails to point to a renewed boom, it does at least suggest a return to fundamentally based gains after the present, bearish psychology runs its course. Meanwhile, any sign that China is succeeding in its fundamental effort to re-orient its economy from its present export base to a more domestic engine of growth should point to less volatility and an ability for stocks to sustain greater multiples and produce stronger gains.

Conclusion

None of this pretends that all is well or risk free. On the contrary, risks about bearish psychology could renew the sell off and extend it for a while yet. Certainly, they will impose volatility. Delays in remedial action could create still more fear. Should policy failure allow the economy to falter or fail to get ahead of a move toward social discord, then the economy would suffer, but more from the social unrest and policy failure than the stock price declines themselves. Though distinct possibilities, these adverse outcomes are, however, not probabilities. The likelihoods still favor continued economic growth. If slower than in the not too distant past, that pace of advance should prove sufficient to meet the economy’s crucial job creation needs and remain considerably faster than growth in the United States and the rest of the developed world. On that basis, it should also prove sufficient eventually to stabilize stock prices and subsequently make at least modest gains.

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