When a major economy sees stock prices drop 18 percent in two weeks, it naturally receives attention. In the case of China, it should not. The Chinese stock market is not a true market. It does not reflect the true profitability of listed firms, it does not reflect macroeconomic trends, it does not reflect, well, anything that matters to the rest of the world.
China has serious economic and financial problems, but they did not appear only a few weeks ago, or last summer, when Shanghai swooned. Beijing is making dubious policy decisions, but this is not new, either. There is a long string of bad decisions to reverse and, if they are not reversed, China is headed toward economic stagnation. That’s what matters, not a fake stock market.
A share price in a true stock market is based primarily on how the company performs, whether it is earnings, revenue, cash flow, or book value. The key word there turns out to be “book,” which rhymes with “cook” — as in the books of many Chinese companies are cooked.
More than 100 Chinese firms have been delisted in the U.S. and Canada owing to accounting problems. The ones that remain within the friendly confines of the People’s Republic are likely worse. We cannot get good information: A year ago, the Securities and Exchange Commission specifically cited China operations of the big four accounting firms for lack of transparency.
If disclosure by listed firms is absent or fraudulent, perhaps stocks are instead connected to general Chinese economic performance. That seems to be the assumption of many analysts — that falling share prices mean the Chinese economy is tanking (and could take the world with it). If this is true now, it would constitute an enormous change, since it has never been true before.
In 2014, the economy was weakening even on official figures, and the Shanghai Composite Index rose 50 percent. Five years before that, China claimed that the biggest monetary stimulus in world history was necessary because 20 million workers had been laid off in the first six months of the downturn. Stocks gained 50 percent in just the first half of 2009, the height of the crisis.
Five years before that, the Chinese economy was beginning its rise to global prominence, riding the crest of explosive trade growth. Shanghai share prices fell 25 percent in 2004. Share prices have repeatedly seen large swings that run counter to the direction of the economy.
Although it’s often unclear what is causing Chinese prices to move, sometimes it’s obviously ham-handed government action. In March 2015, the People’s Bank of China praised money movement into stocks. A month later, when the Shanghai Index had hit 4,000, the People’s Daily called it the “beginning of China’s bullish market.” Since then the index has fallen more than 25 percent.
The Chinese government’s mismanagement extends beyond the stock market, to developments that are much more important to the world economy. The obvious issue is the exchange rate.
The government’s response to market weakness has been worse than its horribly timed cheerleading. Last summer, trading restrictions froze the market for a few days but did nothing to prevent further declines. Nothing was learned by this year’s round, as a new circuit-breaker to more quickly stop trading backfired and was almost immediately removed.
Dangerously Bad Policy
The Chinese government’s mismanagement extends beyond the stock market, to developments that are much more important to the world economy. The obvious issue is the exchange rate, on which the Chinese government has made surprise policy changes, in August 2015 and this month, triggering or at least intensifying global stock weakness.
Many countries compete with Chinese production, and the possibility that China will let the yuan drop is a threat to thousands of firms in those countries. Stock markets in Korea, Singapore, and across Asia have reacted accordingly. It is a legitimate question whether a weaker yuan would benefit China; what is undeniably a mistake is China’s failure to follow a clear, consistent path.
Properly guiding the exchange rate seems to be a critical challenge for Beijing, one it is failing to meet. Yet this is child’s play compared with domestic economic challenges. As with every other aspect of corporate books, how much Chinese firms have borrowed is somewhat unclear. It’s in the neighborhood of $18 trillion, compared with American corporate debt of $13 trillion.
Moreover, most of the debt accumulation is due to deliberate choices by the Chinese government. State-owned enterprises account for (roughly) two-thirds of the corporate debt total. And debt began to soar when Beijing decided in late 2008 to force state banks to lend, even while profit opportunities were vanishing in the financial crisis.
China is far from rich, with personal disposable income of $3,500 annually. For China to become rich will be exceedingly difficult, given its mountain of debt. Those companies and countries hoping for a wealthier and still-growing China to boost their bottom lines should have started to adjust in 2011, as Chinese debt soared and the economic trajectory turned south; they may be starting to adjust now.
China has other economic failings as well. Perhaps the best way to fight debt is through innovation. Innovation is hard to measure and therefore controversial, but competition is key to its spread through an economy and to its ability to boost productivity. The Communist party still does not like competition.
While Beijing at a much-applauded meeting in late 2013 assigned a “decisive” role to the market, it seems the party means the monopoly capitalism that Adam Smith warned against 240 years ago. In energy, metals, rail, shipping, and other sectors, Beijing seeks a single-state entity with no competitors. China can still innovate to some extent through purchase or theft of intellectual property, but, given debt and a population that will rapidly age, that’s not nearly enough.
Pick Your Poison
Stocks are plummeting again in New York. If this is a short-term move due to prices in Shanghai, it does not make sense. Chinese stock trading is a farce. But if global stocks are seeing a belated, long-term move down owing to Chinese exchange-rate mismanagement, embrace of monopoly, and enormous corporate debt, then it makes perfect sense.