Shanghai Flu, Global Cold?

March 05, 2007

The sharp fall in Shanghai's stock market last Tuesday, February 27, continues to unsettle global markets and raise concerns that China might become the source of yet another potential pandemic - this time a financial one. At a minimum, the flu in China's market has given world financial markets a cold, and one that seems to be getting worse. The nearly 9% one-day drop in the Shanghai market, the worst fall in ten years, erased about $140 billion in value and prompted sell-offs in the US and other global markets in the 3-4% range. As of Monday, March 5, US stocks appeared to stabilize, but sell-offs continued in Asian and other global markets. The fall in the comparatively miniscule Shanghai exchange immediately played into wider concerns about a possible U.S. recession, which would have global impact. Despite assurances by Fed Chairman Ben Bernanke about the current soundness of the US economy, American and foreign investors remain nervous both about China and the global economy.

For years the more cautious stock analysts of Asian markets have warned investors away from "frothy" Chinese and other "emerging market" equities, but the chase by investors for higher returns has caused them to accept a comparatively high degree of risk. For the past two years foreign investors have continued to pour money into the Shanghai market with full knowledge that the books on most Chinese companies are unreliable. The Shanghai exchange is dominated overwhelmingly by small investors seeking to increase their household savings and keep ahead of inflation, not by experienced institutional investors as tends to be the norm on Wall Street and other major exchanges. Most of the listed companies are fully or partially state-owned, and many of these companies' books are of questionable credibility. Chinese investors themselves tend to view the equity markets as just another form of gambling, with ups and downs unconnected with underlying value. News of big losses for a state-owned or state-connected company may actually push up its stock if investors calculate that the government will step in to rescue the failing enterprise.

Even after last week's tumble Chinese day-traders continue to show more confidence than foreigners, who trade in a different group of U.S. dollar denominated stocks known as B shares. On Monday, March 5, the Yuan-denominated A shares fell by only 1.6 percent, while the dollar denominated B shares fell by 6.9 percent.

The immediate cause of last Tuesday's sell-off continues to be argued by analysts. One specific factor appears to have been an announcement, quickly retracted, that the Chinese government planned to increase in the capital gains tax. Another was that the authorities had announced plans to crack down on a specific group of real estate companies suspected of illegal property acquisitions and tax evasion. The market's response suggests that investors themselves share the government's view that speculation has largely been the driver of the run-up of stock prices in recent months, including many companies involved in real estate. In a more fundamental way, the problem for Chinese stocks does not stem from actions taken by the government, whatever the immediate effect, but the failure of the government to act for too many years. Most foreign analysts remain bullish on the Chinese economy in the long run, but evidence of a stock and real estate "bubble is strong. Many disinterested observers have read articles and seen pictures detailing the excesses of some of China's new rich and wondered how long the "party" would last.

The "real economy" in China, manufacturing, agriculture, commerce, and government spending, remains robust, but Chinese leaders have a large array of problems to address, and their ability to fix them is coming into question.

A short list includes:

• A shaky banking system saddled with huge non-performing loans, most of them to state-owned industries and companies with questionable business practices and doubtful prospects for repaying their debts;
• The inability of the central government over a period of years to force the state-owned banks as well as provinces and municipalities to stop enabling rampant property speculation;
• Export-oriented growth policies that involve various types of subsidies to companies and workers, that swell the budget deficit;
• Growth that relies excessively on domestic investment in factories and infrastructure rather than consumption, much like the Japanese bubble of the late 1980s, leads to overpriced assets and excess manufacturing capacity;
• The policy of "sterilizing" the county's $1 trillion plus hard currency reserves from the Chinese domestic economy so that the government can maintain an undervalued Yuan and keep the export machine humming; and,
• A growing and potentially destabilizing income gap, especially between the rural North and West and coastal South. The list could go on.

A serious and prolonged downturn in the Shanghai exchange could affect a number of US interests. These include our own equity and commodities markets, and financial stability more generally, and a possible a weakening of the dollar against the Japanese Yen as Asian and other central banks seek more exchange rate stability by selling some of their dollar holdings. From one perspective, the effect of a weaker dollar on the US economy would have a mixed effect, making American exports cheaper and imported goods more expensive, thereby helping to reduce the huge global US trade deficit.

From a broader and more strategic perspective, a declining dollar tends to limit a range of US policy options, unsettles global markets, and could provoke a wider sell-off by foreign central banks and investors of some of their several trillion dollars worth of US Treasury bonds that help finance the substantial US budget deficit, leading to higher US interest rates. American foreign policy and security interests would also suffer if a deeper sell-off of Chinese stocks led to a financial crisis and domestic instability. For instance, the concept of accommodating China's rise by encouraging it to be a responsible "stakeholder" cannot work if China is not stable and self-confident.