China’s Reaction To Its Stock Crash Will Not Be Enough
By doing too little too late, there will be economic and demographic consequences for decades
(Not intended to be investment advice, opinions are my own.)
China’s policy makers are trying to stem the Chinese stock market crash by preventing institutions and brokerages from either selling shares or using derivatives to short the market. This reaction tells me two things:
- Policy makers in China are getting desperate.
- Chinese policy makers misunderstand the problem and still think that the stock market crash is driven by overly negative (and in their opinion incorrect) sentiment rather than structural holes in the economy.
I think Chinese policy makers are wrong about point 2. China is facing real solvency issues in its local governments, financial sector, and real estate sector. The continued slide in real estate is especially worrisome as that sector is both a huge and important portion of its economy at 25% of GDP as well as the biggest store of its citizens wealth. Without drastic action China is facing a lost decade similar to what Japan experienced post the crash of its bubble.
Worrying signs
The most telling signs are deflation and youth unemployment. Youth unemployment is a really bad sign because it’s a clear sign that the economy is not growing. A nation’s youth are both a key source of consumption (as they enter the labor force, start earning more, and eventually form households) as well as a big driver of long term growth. The fact that so many of China’s youth (including vast amounts of college graduates) can’t even earn a starting foothold on the career escalator means that as a group their future lifetime earnings and purchasing power will be drastically lower.
A properly functioning economy’s job is to develop its young, hungry, and talented. When a country fails to do that year after year, it experiences a brain drain (i.e. an outflow of talent) that can permanently impact its growth trajectory.
Deflation is the economy killer
Deflation is obviously bad for an economy as it’s a clear sign that people are not interested in consuming or can’t afford to. Deflation is doubly bad because it becomes a self reinforcing force where people expect prices to go down and the value of currency to rise, so no rush to buy now they think. In deflationary periods, the rational thing to do is to delay purchases and hoard cash. But when everyone does this, the economy crashes.
Deflation also makes it harder and more painful for debtors to service their debts because it raises the real cost of borrowing by raising real interest rates. The high real cost of debt and the perception that there are no good investment opportunities (thanks to geopolitical tension and a multiyear equity market decline) has severely slowed credit expansion and investment spending in China. Even tier 1 city (i.e. Beijing, Shanghai) homes are dropping in price — a few years ago these were the crown jewels of Chinese investors’ portfolios and levering up to buy these properties was seen as a risk-free and high reward trade. No longer.
Limited room for monetary easing
The nominal yield on China’s (10 year) government bonds are already pretty low at 2.3% (versus America’s 4.1%). This limits the amount of non-QE (quantitative easing) monetary stimulation that China can do. This is key because China’s policy makers want to avoid rekindling the debt animal spirits if they can. Debt, especially shadow debt that goes unreported in the official stats has been a major concern for the Chinese government for more than a decade now. This concern was what pushed policy makers to crack down on the real estate sector in the first place. Thus, it’s my belief that while Chinese policy makers may eventually lower rates, they will not go ahead with QE.
QE encourages credit expansion — by printing money to buy bonds held by banks, it simultaneously lowers long term interest rates and increases the amount of cash held by banks (which can then be lent). In terms of stoking froth, QE is more potent than lowering interest rates because it not only affects the cost of debt (i.e. interest rates) but also the amount of dry powder that banks have to lend.
After all, the point of QE is to encourage risk taking (by lowering the yield on safe assets of all durations) and credit expansion. While China would love to see a recovery in its equity markets, it greatly fears going back to the days of unchecked credit expansion. This is likely why its efforts thus far to right the ship have seemed like too little too late. But given how low its interest rates already are and how badly its economy is doing; without a massive dose of QE, it likely won’t be able to fix things. So it’s basically a case of the patient refusing to take the medicine.
Are valuations gloomy enough?
An interesting question is whether equity valuations in China are now overly pessimistic and discounting too gloomy of an outcome. Perhaps, but at least for me the geopolitical risk plus the real likelihood of a nasty feedback loop of deflation and recession that the economy can’t escape is still too much. Also concerning are the possibility of increasingly strict capital controls that push those that can sell to get out while they can as well as policy makers’ stubborn focus on ideology over economics.
China’s latest economic crisis has gone on long enough that it will have long-lasting effects on its demographics (fewer people willing to have and able to afford children), attractiveness to foreign investors, and future productivity (talent and capital are fleeing to less restrictive and faster growing countries). A few years ago people were confident that it was just a matter of time before China’s economy surpassed America’s. Now that day might never come to pass.
