In a effort to transition from an export-based economy to a services-economy, like the U.S. economy, China had to get consumers to spend more. Understanding the “wealth effect” that people spend more when the stock market is up, the Chinese government and their central bank decided to pump up the market by goosing up margin investing and increasing money supply Their margin debt now equals 8% of GDP, compared to only 2.8% here. This was incredibly irresponsible monetary management. Predictably, their stock market boomed. In fact, it boomed too much and promptly collapsed. Obviously, consumer spending also collapsed, and some rioting quickly began.
While I have been to Asia several times, I’ve only been to China twice. That certainly doesn’t make me a scholar, but I do have a clear idea of the one thing Americans don’t understand about the Chinese Communist Party, i.e., they are deathly afraid of social unrest. Not even the Communist Party can control a billion unhappy people. It is not an over-statement that they are obsessively paranoid about social unrest. This is the reason they continued to meddle with their stock market this month, briefly driving it back up before today’s collapse.
Following the market collapse, the government took a number of steps that would spell disaster in a free society. They made margin investing even easier, they lowered interest rates again, and they banned all IPOs because that sucks money out of the market. Incredibly, they even outlawed short-selling or betting on stocks going down. Yes, they criminalized a legitimate investment technique.
Expect more social unrest and more draconian measures in China!
More concerning to the world’s stock markets is the fear that other stock markets could meltdown like China last month or Russia last year. While the Russian meltdown was due to the price of oil collapsing and the initial economic sanctions, the Chinese meltdown was due to regulatory negligence. If the Chinese wanted to orchestrate a meltdown, they would not have done one thing differently. If there is ever an economic horror movie, this is it!
Of course, there are some important differences between the U.S. and the Chinese stocks markets. As a percent of GDP, their stock market is tiny compared to our’s. This was one of China’s justifications for pumping up their stock market. Another difference is that most stock trading is by retail investors, which are ordinary people, unlike the U.S. where most are institutional investors. China accidentally increased the possibility of social unrest among retail investors by meddling with their stock market. Most importantly, the collapse of the Chinese stock market is unrelated to derivatives trading. For this reason, the contagion effect will be limited.
The world’s second largest economy (15% of world GDP) is slowing down faster than the world’s largest economy (the U.S. at 25%) is picking up. China has been the world’s economic engine for 15 years, but that is slowly shifting back to the U.S. — too slowly. (I believe there is no chance the Fed will raise interest rates this year!)
While most analysts expected to Chinese economic to drop below 7% this year, causing a worldwide decline in commodities, those estimates of GDP will soon be dropping even more, as the Chinese economy experiences some drag from its financial crisis. Keep in mind that this drag will not put China into recession, as their growth will remain positive, just less positive, like 4% maybe.
However, there remains the fear that corporate earnings worldwide will be hurt if China slows down faster than the U.S. and Europe speed up. Earnings this quarter, so far, appear to slowing – not as much as predicted but slowing anyway. I expect some drag on the U.S. stock market but certainly not a collapse.
Don’t you miss that Greek horror flick on the world stage? They will return . . . and so will China!