The slow-motion train wreck in Chinese stock markets these past few weeks reminds me of Winston Churchill’s observation, in August 1914, that “the terrible ‘ifs’ accumulate.”
No, a stock market slump in China is not as important or devastating as World War I. Indeed, it may turn out to be a flash in the pan. The Shanghai market climbed down from an even higher peak eight years ago without triggering disaster. But the seriousness of the current situation, particularly the very many unknowns, should not be dismissed.
The number and magnitude of the “ifs” are great. Virtually every important aspect of the situation is one of true “uncertainty” – in the sense that economists use the word. No one knows what will happen and there is no statistical basis from which to calculate probabilities of different outcomes.
Yes, we can study the “lessons of history,” and make subjective guestimates, but these really are shots in the dark.
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So what are some of the important ifs?
First, how will this affect anyone in our country, if at all? That is the question posed in emails from two readers, prompting this column. We know China has been an importer of U.S.-produced goods.
How this plays out depends on the “mechanisms” by which economic “shocks” are transmitted internationally. Some of these are clear, such as reduced demand for imports by a country undergoing a crisis. In this case, we’ve been seeing this for well over a year.
Chinese demand for iron ore, copper, timber and a myriad of agricultural products produced in our country has already ebbed. The “commodity super cycle” that some observers identified is over. But we don’t yet know if we are near the bottom in commodity prices. We don’t know how any further softening will affect farmers, miners or manufacturing workers across the country.
That is one of several reasons for softening farm land prices just as much as the economic slumps in Brazil and Argentina.
We also know that China, along with the European Union and the United States, is one of the key components of the global economy. There are large trade and investment flows between China and our nation. The greater the economic disruption in China, the greater the probability and magnitude of effects here. But the size and details of such linkages are unknowable before the fact.
Second, just how much will Chinese stock markets fall?
That is an unanswerable question for any stock market. But the Chinese one is particularly opaque. It is only in its fourth decade of existence and has had only one major downturn. To many observers, it is clearly overpriced and in an unsustainable bubble. Yet some Nobel-winning economists deny that bubbles even exist. I’m in the camp that there is a lot of air in these exchanges and that the fall could be fast and deep. The government flooding the economy with money cushioned the 2007-2009 fall, but China’s overall financial situation is far more fraught after another six years of expansion.
One cause for concern is that, as in the 1920s in the United States, China has had a high level of buying stocks “on margin,” or in other words, with borrowed money. The stock is collateral for the loan to buy it. As stock prices drop, owners are forced to sell shares to repay the loans. This dumps additional shares into a falling market, exacerbating the drop. By some accounts, the Shanghai exchange is the most highly-margined stock market in modern history. If true, there is greater danger of economic disruption.
Third, does even a deep slump in Chinese stock prices mean there will be broader financial problems in China?
So far, attention is focused on stock markets, but the entire structure of Chinese finance is rickety. As is always the case with booms that go on for nearly four decades, lots of unsafe loans eventually get made. A whole generation of Chinese bankers, investors and government officials has come and gone since former Chinese ruler Deng Xiaoping opened the country up to foreign commerce in 1978.
Both the public and private sectors suffer from overconfidence. And, because China is still much more of a central-planned economy than people realize, directions from government on the allocation of credit have made the misallocation of credit worse rather than better.
Moreover, as before the U.S. Panic of 1907 and in the run-up to 2007-2009, an unregulated “shadow banking” sector has arisen alongside of regulated commercial banks. Largely unregulated and highly opaque investment funds handle enormous sums. Little reliable information is available.
In other words, there are lots of pitfalls in Chinese financial sectors. History tells us that deep drops in stock prices often spill over to become generalized financial crises. That is likely in this case.
Even if there is a broad financial crisis, will the underlying Chinese “real economy” go into recession? Must falling stock prices or failing banks reduce production of rice, steel, clothing or anything else? Must it drive up unemployment?
In theory, not necessarily. However, much historical precedent shows it is hard for a modern economy to avoid a recession when there is a broad financial-sector crisis or even a narrowly confined stock market slump.
One reason is the “wealth effect” of households cutting spending when the value of their savings go down. Another feature of the past decade is the broadness of participation in Chinese stock markets. It may not include the proverbial shoeshine boys of 1920s Wall Street, but direct share ownership is very broad. And most households also may have money in “shadow” investment funds that are vulnerable to financial tremors.
The problem is exacerbated by the fact that when Deng turned the country away from Maoism, social safety nets were slashed. Modern Chinese households are very dependent on their own savings and the population is aging. There are not large numbers of children to support parents. So sharp drops in stock prices or failure of investment funds could bring catastrophe to many.
Similarly, employment depends on credit for current cash flow and credit for investment in new plants and equipment on the part of manufacturers, builders and other real-economy businesses. If credit dries up, as it usually does in a financial crisis, these businesses must slow and unemployment rises.
A salient problem for China is that economic chaos means political crisis for authoritarian regimes that lack the inherent legitimacy of democracy.
As for the financial sector, 37 years of growth have lulled observers, both Chinese and foreign, into a “this-time-it-is-different” mentality – the belief that real output growth falling to 6 percent or so is the worst recession China could possibly have. Don’t kid yourself.
So while I hate the genre of “the coming crash of ... “ books, I think what unfolds in coming months in China is likely to be far more important than Greece or anything in the EU.
China’s purchases of U.S. dollars and of euros to keep its own currency cheap, and hence exports high, is one cause of the bubbles in its financial sector. How will the government of China, including its central bank which has no autonomy, react if things seem to slip out of control? And how will that affect U.S. financial markets, U.S. government finance, and the Federal Reserve?
Again, no one knows and, ultimately, no one can know.
St. Paul economist and writer Edward Lotterman can be reached at firstname.lastname@example.org.