China’s Transitions Should Not Freak Us Out

By Roy C. Smith

In December 2014 I wrote a column for eFinancial News noting the 25^th anniversary of the great Tokyo market crash of 1989, after which all traces of Japan’s decade-long standing as an emerging economic superpower disappeared forever. The column compared Japan’s rapid postwar economic development and vulnerabilities with China, which has followed a similar economic strategy and now faces similar difficulties.  At the time no one paid much attention. China’s growing power was indisputable, and indeed, China was then beginning a broad economic effort to offset declining growth rates by stimulating domestic consumption.

The immediate impact of this effort, largely implemented by local and provincial governments and SOEs, was to inflate stock prices by about 200% over a nine-month period. The bubble collapsed last summer, and the government (similar to Japan in 1990) launched a series of heavy-handed efforts to force markets back to normal. These efforts worked for a while, but as soon as they were withdrawn, selling began again. The government’s interventions had in fact made the stock market riskier and more uncertain.

This year, stock markets have got off to one of their worse starts ever, largely because of an outbreak of further selling in China, complicated by “circuit breakers” that close markets after daily declines of 7% or so. (The New York Stock Exchange’s circuit breaks trip at a 20% change).

Western observers have interpreted the Chinese selling (SHCOMP is down 18.0% so far this year, despite considerable government support) to mean that the debt-laden Chinese economy will crash and drag down all the others.  The MSCI Emerging Market index is down 9.6% on the year, and even the S&P500 is down 8.4%

China’s economy does have some serious problems. Its estimated 2016 GDP growth rate is less than 7% -- the lowest since 1993 except for one-year crisis-driven drop to 6% in 2009 -- and many observers who now distrust Chinese economic data discount even this rate.  Conventional wisdom in and about China seems to hold that growth below 7% could generate widespread social unrest that could threaten the Communist Party control of the country.

This being the case, President Xi and his party have a great interest in using their considerable powers and skills to revive the economy.  When Xi came into office he appeared to understand that a major priority had to be to shift economic output from the export to the domestic sector, and for this to happen, market forces would have to play a more important role.

But market forces are hard to control, as the government has just discovered.  The dilemma for China is how much to rely on market forces to make the necessary transition to domestic consumption if these forces have such uncertain outcomes. Even so, China has sufficient market activity now to make a reversion to traditional “command” economics impracticable.  Mr. Xi and his colleagues have a lot at stake in getting this right.

In 1989 Japan was the world’s second largest economy; its market crash took about two years to reach bottom, where it remained for several more years. The early 1990s were stressful times in Western markets, but these markets recovered and were not much interested in what was happening in Japan.

Compared to the size of its economy, Chinese stock markets are small and should have minimal impact on Western markets. Fears of the contraction and of a credit crisis in China will reduce Chinese demand for imports (including oil), and lower its exchange rate, but not otherwise have lasting significant impact on US and EU economic conditions.

But the “three transitions” that China must make over the next decade – to domestic markets, to freer markets, and to improved political rights and opportunities -- will make things better in China over the long run s they have in other formerly authoritarian states like Taiwan and South Korea.  The Chinese transitions might be painful within China, but until they are completed, China’s role as an enduring economic superpower must be questioned. In any case, the transitions  are necessary and should not frighten us.

From eFinancial News Jan 13, 2016