The Chinese government's scramble to prop up its stock market in the face the recent mass sell-off could prove more damaging than the sell-off itself. Had Beijing not intervened, the sharp drop in share prices would have probably had a limited impact on the real economy.
$4 trillion market loss hits the state, not consumers'
But instead the government's actions cast doubt on its willingness to relinquish control in more important markets: credit and currency. Rather than proceed with the reform agenda, these actions risk a further build-up of excess capacity and debt in the economy, and undermine efforts to rebalance to a more sustainable growth model.
And by staking its reputation on halting the stock market crash, the government risks a crisis of confidence, which in turn could undermine the effectiveness of future policy moves aimed at fuelling growth.
Sell-Off Was No Major Threat to Consumer Spending
Taking the claim that China's stock markets saw $4 trillion in wealth wiped out in just a few weeks at face value, one might expect Chinese household finances to be in dire straits. The drop in equity markets in the month following the June 12 peak was equal to nearly 40% of China's GDP. While technically accurate, the $4 trillion in wealth destruction overstates the blow to Chinese household finances and, in turn, the threat to consumer spending.
First consider that the crash came immediately after a staggering amount of wealth creation in the previous 12 months. Despite the summer's steep decline, the combined market capitalisation of the Shanghai and Shenzhen exchanges is still $3.6 trillion higher today than it was a year ago.
Second, because the Chinese government, via its ownership of listed companies, is the dominant shareholder in China, most of the $4 trillion paper loss hits the state's balance sheet, not consumers'.
In fact, relative to consumers in most major economies, Chinese households are underweight equities. According to the most recent data published by the People's Bank of China, at the end of 2013, stocks accounted for a mere 8% of Chinese household financial assets. That compares with 63% of financial assets in bank deposits.
After accounting for the 66% increase in the Shanghai Stock Exchange Composite Index since year-end 2013 and accumulation in household bank deposits, we estimate that stocks might make up around 10%-12% of household financial assets today. Even this would overstate how much household wealth is tied up in equities, since real estate investments are not included in the Public Bank of China's measure of financial assets.
The Cure Is Worse Than the Cold
Given our view that the sharp drop in Chinese equities would have had only a modest impact on the real economy, we were surprised that Beijing intervened so aggressively to halt the sell-off. The range of weapons it deployed was staggering, ranging from liquidity injections to editorial cheerleading to threats of criminal prosecution.
The scattershot approach suggested a hint of desperation. The government's panicked and initially ineffectual response raises three major risks that we believe are more dangerous than the stock market crash itself.
1. Beijing's Decision to Intervene in the Stock Market Casts Doubt on Key Reforms
The government's actions suggest a lack of commitment to President Xi Jinping's much-heralded pledge to cede a "decisive role" to the market, or at least a belief that China can somehow enjoy the benefits of market liberalization without the costs that come with it. This leads us to question the future of real reform in China's credit and currency markets, which are far larger and more important to the real economy than the stock market.
If Beijing is unwilling to accept falling share prices, it seems unlikely it would tolerate the far more serious matter of widespread bankruptcies that would occur if interest rates were fully liberalised.
2. Failure to Implement Key Reforms Would Heighten the Risk of a Debt Crisis and Diminish the Economy's Long-Term Growth Trajectory
Although allocating credit according to market principles would lead to widespread defaults, or bailouts, of technically insolvent state-owned enterprises and local governments, maintaining the status quo would leave them free to continue the ill-conceived overinvestment they've been pursuing for the past several years. Excess capacity spanning infrastructure, real estate, and manufacturing and a growing debt burden would swell further, increasing the chance of a true debt crisis.
By postponing reforms or attempting to implement "one-way" market liberalization, Beijing not only increases the chance of a crisis, but diminishes its chances of maintaining robust economic growth over the long haul. Maintaining preferred credit access and artificially low rates for the state sector perpetuates the transfer of wealth from household savers.
3. Beijing's Initial Failure to Halt the Rout Risks Denting its Credibility as an Economic Powerhouse
The Chinese government has built up enormous credibility over the past several decades. The view that Beijing can steer China's economy on the path it desires is widely held in China and abroad.
To an extent, this confidence has been rightly earned. No other major economy in recorded history has achieved the sort of consistent high growth that China has in the past three decades. And the government has no shortage of levers to pull in a bid to get what it wants.
Beijing's success is self-perpetuating. If Chinese corporations and households are confident in the government's ability to deliver growth, they'll behave in way that fosters growth. Corporations are more likely to invest on the basis of demand that might be just around the corner.
Just as confidence has been critical in keeping growth elevated, a loss of confidence would prove just as self-fulfilling. Future policy moves aimed at stoking growth would gain less traction if corporations and households lose faith in the government's ability to deliver growth.
