Commentary

Shanghai Flu, Global Cold?

in Program

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.

 

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