China’s Stock Plunge Is Scarier Than Greece
There are four basic signs of a bubble, and the Chinese stock market is on the extreme end of all four.
A stock-market display in Shanghai, China, July 6. PHOTO: PEI XIN/ZUMA PRESS
China’s state-sponsored stock-market rally is unraveling, with potentially dangerous consequences. The first major sign that all wasn’t going according to script came on June 15. Chinese had awakened expecting big gains because it was President Xi Jinping’s birthday, but the Shanghai market fell more than 2%. One deeply indebted day trader committed suicide by jumping out a window, his net worth wiped out by the collapse of a single stock that he had borrowed heavily to purchase. The market has since fallen by another 25%—and some fear that prices could go much lower.
In most countries, no one thinks there is a link between a leader’s birthday and the market. That such a theory prevails in China reflects the widespread belief that Beijing’s authoritarian government can produce any economic outcome it wants. Now trust in China’s ability to command and control the economy is faltering. If trust collapses, the global repercussions could be more severe than those from the Greek debt crisis.
Opinion Journal Video
Silvercrest Asset Management Managing Director Patrick Chovanec on Beijing's efforts to prop up prices and the potential political fallout. Photo credit: Getty Images.
When China’s economy slowed following the 2008 global financial crisis, Beijing pumped massive amounts of liquidity into the system. First that money went into the property market, later into the various debt-related products sold through the shadow banking system. But when property slumped and the shadow banks started to pose systemic risks, China had only one major market left to flood—stocks.
Funneling some of China’s $20 trillion in savings into stocks was a last-ditch effort to revive flagging economic growth by giving the country’s debt-laden companies a new source of financing. The aim was to trigger a slow and steady bull run, but the somnolent stock market exploded into one of the biggest bubbles in history.
There are four basic signs of a bubble: prices disconnected from underlying economic fundamentals, high levels of debt for stock purchases, overtrading by retail investors, and exorbitant valuations. The Chinese stock market is at the extreme end on all four metrics, which is rare.
The sharp equity rally took place despite sputtering economic growth and shrinking profits. By official count, margin debt on the Chinese stock market has tripled since June 2014. As a share of tradable stocks, margin debt is now nearly 9%, the highest in any market in history. At the leading brokerages, 80% of margin finance has been going to retail investors, many of them new and inexperienced.
Today China’s 90 million retail investors outnumber the 88 million members of its Communist Party. Two thirds of new investors lack a high school diploma. In rural villages, farmers have set up mini stock exchanges, and some say they spend more time trading than working in the fields.
The signs of overtrading are hard to exaggerate. The total value of China’s stock market is still less than half that of the U.S. market, but the trading volume on many recent days has exceeded that of the rest of the world’s markets combined. Turnover is 10 times the level seen at the peak of the previous China bubble in 2007, and virtually the entire market inventory is changing hands every month. Such frantic activity has pushed up valuations for companies large and small, with the broad CSI 500 index trading at 50 times last year’s earnings and the Nasdaq-style board Chinext valued at 110 times last year’s earnings.
Since the June 12 peak, nearly $3 trillion in value has been erased, as Beijing takes increasingly desperate measures to arrest the price collapse. The authorities have cut interest rates and transaction fees. They have directed mutual funds and state pension funds to buy stocks. Over the weekend they panicked and reversed course by suspending new initial public offerings, suddenly choking off a source of the new corporate funding they had been trying to create. This comes when the real cost of corporate borrowing is high. Any further reduction in interest rates could accelerate the outflow of capital, after a record $300 billion has already left China this year.
The continuing crisis is viewed, locally and globally, as a test of China’s control over the economy. The “Beijing put”—a perception that Chinese economy and markets are backstopped by the government—is under threat. That perception has underpinned the widespread belief that Chinese growth won’t fall much below 7%, because that is the government’s desired target and Beijing is omnipotent.
Looming over all of this is China’s massive run-up in debt, which has increased by over $20 trillion—to around 300% of GDP—since the global financial crisis in 2008. All along, the bulls argued that Beijing has successfully managed every challenge to its three-decade economic boom, and that it could overcome the threat this debt represents. At a minimum, the argument went, China’s financial woes would be smaller than those of other countries with high levels of borrowing. This faith in Beijing encouraged many global hedge funds to pile into Chinese stocks.
But if Beijing can’t stop the market’s tumble, there could be a sudden shift in the perception of exactly how far economic growth might fall under the weight of too much debt. If that floor crumbles and the Chinese economy spirals downward, it will make the drama surrounding Greece feel like a sideshow. China has been the largest contributor to global growth this decade; Greece’s economy is about the size as that of Bangladesh or Vietnam.
There is no global drama that bears closer watching than Beijing’s battle for control.
Mr. Sharma is the head of emerging markets and global macro at Morgan Stanley Investment Management and the author of “Breakout Nations: In Pursuit of the Next Economic Miracles” ( Norton, 2012).
