NEW YORK - The problems with China’s economic growth pattern have become well known in recent years, with the Chinese stock market’s recent free-fall bringing them into sharper focus. But discussions of the Chinese economy’s imbalances and vulnerabilities tend to neglect some of the more positive elements of its structural evolution, particularly the government’s track record of prompt corrective intervention, and the substantial state balance sheet that can be deployed, if necessary.
In this regard, however, the stock-market bubble that developed in the first half of the year should be viewed as an exception. Not only did Chinese regulators enable the bubble’s growth by allowing retail investors — many of them newcomers to the market — to engage in margin trading (using borrowed money); the policy response to the market correction that began in late June has also been highly problematic.
Given past experiences with such bubbles, these policy mistakes are puzzling. I was in Beijing in the fall of 2007, when the Shanghai Composite Index skyrocketed to almost 6,000 (the recent peak was just over 5,000), owing partly to the participation of relatively inexperienced retail investors.
At the time, I thought that the greatest policy concern would be the burgeoning current account surplus of over 10 percent of GDP, which would create friction with China’s trading partners. But the country’s leaders were far more concerned about the social consequences of the stock-market correction that soon followed. Although social unrest did not emerge, a prolonged period of moribund equity prices did, even as the economy continued to grow rapidly.
In 2008, it was a combination of exploding asset prices and excessive household sector leverage that fueled the global financial crisis. When such a debt-fueled bubble bursts, its effects are transmitted directly to the real economy via household-sector balance sheets, with the reduction in consumption contributing to a decline in employment and private investment. It is much harder to find circuit breakers for this dynamic than for, say, that caused by balance-sheet distress in the financial sector.
Yet the Chinese authorities seem not to have learned the lessons of either episode. Not only did they fail to mitigate the risks, underscored in the 2007 collapse, that new retail investors introduce into the market; they actually exacerbated them, by allowing, and even encouraging, those investors to accumulate leverage through margin buying.
Making matters worse, when the current stock-market correction began in early June, Chinese regulators relaxed margin buying restrictions, while encouraging state-owned enterprises and asset managers to purchase more stocks. The authorities, it seems, were more interested in propping up the market than allowing for a controlled price correction.
To be sure, China’s stock-market bubble did not emerge until recently. Last October, when the Shanghai Composite Index was in the 2,500 range, many analysts considered equity prices undervalued. Given relatively strong economic growth, rising prices seemed justified until about March, when the market, driven by mostly thinly traded small- and mid-cap stocks, shot to over 5,000, placing the economy at risk. (And, in fact, many still claimed that the rally was not unsustainable, as the stock market was trading at a forward price-to-earnings ratio of about 15, consistent with its ten-year average, in mid-April.)
But it was a bubble — and a highly leveraged one at that. While periodic bubbles may be unavoidable, and no bubble is without consequences, a highly leveraged bubble tends to cause far more damage, owing to its impact on the real economy and the duration of the deleveraging process.
This is reflected in the persistently sluggish recovery in the advanced economies today. Even the United States, which has fared better than most since the crisis, has recorded GDP growth of little more than 10 percent since the start of 2008; over the same period, China’s economy grew by about 66 percent.
Of course, with China’s household sector holding a relatively small share of equities compared to real estate, the current stock market slump is unlikely to derail the economy. Nonetheless, as in 2007, the prospect that lost savings will trigger social unrest cannot be dismissed, especially at a time when tools like social media enable citizens easily to share information, air grievances, and mobilize protest.
As previous crises have shown, and as the current downturn in China has highlighted, steps must be taken to mitigate market risks. Specifically, China needs prudential regulation that limits the use of leverage for asset purchases. Here, the country already has an advantage: relatively high levels of equity and low mortgage-to-value ratios typically characterize real estate purchases by China’s household sector.
Moreover, once a market correction begins, the authorities should allow it to run its course, rather than prop up prices with additional leverage — an approach that only prolongs the correction. If Chinese regulators allow the market to correct, sophisticated institutional investors with a long-term value orientation will ultimately step in, enhancing the market’s stability. In the interim, the use of public balance sheets to purchase enough equity to prevent the market from over-correcting may be justified.
As China’s markets expand — the capitalization of the Shanghai and Shenzhen markets is on the order of $11 trillion — they are increasingly outstripping policymakers’ capacity to manage prices and valuations. The only practical way forward is for the Chinese authorities to focus on regulatory and institutional development, while following through on their commitment to allow markets to play the decisive role in allocating resources.
Michael Spence, a Nobel laureate in economics, is a professor of economics at New York University’s Stern School of Business and a senior fellow at the Hoover Institution. © Project Syndicate, 2015 www.project-syndicate.org