Stock Markets Vex China's Leaders
Since mid-June, the Shanghai Stock Exchange Index has declined by about 30 percent. While a precipitous fall of share prices is worrisome, even after the recent market routs the Shanghai index is still some 65 percent higher than it was a year earlier, while the shares of China’s small- and medium-cap companies remain among the most expensive in the world.
Still, Chinese leaders appear determined to reverse the market declines. Some of their measures have been extreme and sweeping: a massive share-purchase program by the government, prohibiting sell-offs by major shareholders, banning new I.P.O.s, suspending trading of many shares, investigations into short-selling “with a malicious intent,” and dispatching a public security official to examine trading records.
The bull run started a year before the tumble in June. The Shanghai index was at 2,051.71 points on June 12, 2014, and it peaked at 5,166.35 on June 12, 2015. Before this surge, the most significant contribution of China’s stock markets had been their irrelevance to the real economy. The Shanghai index hardly increased between 2000 and 2013 — except for 2007, the year of euphoria before the Beijing Olympics — while the Chinese economy grew rapidly, overtaking Japan as the second largest economy in the world. By comparison, the Sensex index in Mumbai quintupled in the same period, in a country that many consider an economic laggard compared with China.
But during the bull run preceding the June crash, the financial sector became linked to the rest of the economy through the extensive use of margin trading — the practice of using borrowed funds to purchase shares. Margin debt increased fivefold during this period, and it was the singular force that fueled the market rise. Chinese financial regulators justified their recent market interventions on the grounds that defaults on the margin trades can pose systemic risks to Chinese banks. There is some merit to this argument, but the logic is similar to the one used by the boy who pleaded for leniency because he was an orphan — after he had killed his parents.
The current mess is entirely due to the active encouragement by the authorities to invest in the markets and to lax regulations. Editorials in People’s Daily, the mouthpiece of the Chinese Communist Party, talked up the market, and regulatory authorities tacitly permitted the dangerous practice of margin trading.
The fundamentals for the market surge were noticeable only in their absence. G.D.P. slowed substantially during this time, and many companies reported deteriorating earnings. The economy’s overcapacity worsened, and Europe, an important trading partner with China, was mired in a recession.
Yet the stock markets surged. This was not irrational exuberance; it was exuberant irrationality.
People outside the small band of policy elite do not know why these leaders chose this course, but there is a long obsession among Chinese officials for impressive G.D.P. numbers. Maybe the statistical hawks gained the upper hand in arguing that anything short of miracle growth would be a disaster for the leadership.
After President Xi Jinping and Premier Li Keqiang ascended to power in 2013, they wisely began to tone down the G.D.P. expectations by talking about “a new normal” — the notion that growth would be around 7 percent a year rather than 9-to-10 percent a year. This was sensible.
After 30 years of supercharged expansion, the Chinese economy is much bigger today — and it is simply much harder to grow fast from a higher base than from a lower base. By 2014, China had picked much of the low-hanging fruit for economic growth, such as simple labor-intensive manufacturing and export processing. To transition to the next phase of growth — powered by technology and innovations — requires time, patience and, above all, economic and political reforms.
Despite the new normal formula, the growth imperative returned. Between November 2014 and May 2015, the central bank cut interest rates three times and then another time in June to support the stock market. This liquidity injection, finding nowhere to go in an economy saddled with overcapacity, helped fund speculation in the stock market. In the short term, the market run provided superficial solutions to a range of problems brought about by G.D.P. slowdowns. Higher valuations make companies look less debt-ridden than they are in reality and, for consumers, rising share prices can make up for the losses of labor income and induce much-needed consumption.
Rather than accepting a moderation of growth rates and deepening reforms, the Chinese leaders pressed on with a risky strategy of inflating and preserving asset bubbles as a way to show they still had the magic touch.
The irony is supreme. One of the singular achievements of the Chinese leaders since 1978 is that they have moved the country away from the Mao era of government omnipotence by opening the country to trade, foreign investment, private entrepreneurship and to a capital market not fully controlled by the state. The Chinese economy boomed not because the state has become more powerful but because the state has become less powerful.
Chinese leaders are often their own worst enemies. They suppress press freedom despite the fact that a free press is the best deterrent to corruption, an endemic problem that Mr. Xi has spent major political capital to combat. They arrest lawyers who check and balance the power of local officials, whose abusive behavior taints the reputation and the legitimacy of the central government. And they picked a mercurial and unpredictable institution — Chinese stock markets — to showcase their skills and know-how to deliver growth.
By unleashing margin trading, the government has inadvertently imported the volatility of the stock markets into what many Chinese believe to be the pillar of stability and safety: the country’s banking system. The amount of wealth lost — estimated between $3 trillion and $4 trillion — is simply too big for any intervention program to make whole. The biggest loss, however, is the credibility of a government that insists on being judged on the basis of omnipotent power it no longer has.
Yasheng Huang is a professor and an associate dean for international programs and action learning at the M.I.T. Sloan School of Management.