First, what happened?
Why did China’s stock markets experience a free-fall during the first week of trading in 2016? The Chinese regulators erred. They installed market-wide circuit breakers into their stock markets. The way a circuit breaker works is that it shuts down and closes the trading day if the market is down by a specific percent. Installing circuit breakers into the Chinese markets was a big mistake. This is not just 20-20 hindsight on my part. I’ve spent a majority of my academic career studying and criticising these kinds of market mechanisms to control volatility artificially. It was this research, in large part, that led to my past appointments with the U.S. Securities and Exchange Commission and with the Kuala Lumpur Stock Exchange. Sure, we use circuit breakers in the New York Stock Exchange, but that’s also controversial. In China, its stock markets already use daily price limits (in China, individual stock prices cannot fall by more than 10% per day), and its marginal investors seem to be the uninformed, speculative, individual investors (a marginal investor is the one that has the power to affect market prices). So, the imposition of circuit breakers was not only repetitive to its price limit system, but it also only served to incite panic rather than to reduce it. Think about it. China is a place where there isn’t a whole lot of transparency to begin with. So, if I’m a somewhat clueless individual investor in China, and one day I see that Chinese regulators suddenly install circuit breakers in fear of a market crash, then naturally I’m going to panic. And this is what happened. The Chinese regulators now see it this way too, which is why they recently removed the circuit breakers. On one hand, this is all comical, but on the other hand, it’s extremely frustrating.
Now, let me address what some people think is true, but is really NOT true.
Some economic data or news justified the Chinese market collapse.
This is not true. I tried to look at every piece of economic news that was announced or released during the first week of this year’s trading in China, and there was nothing that should have justified China’s market free-fall. I read the many international news stories that tried to pin the blame on some economic news, but every explanation that was offered was neither convincing nor plausible. You might think that this is not possible, that every stock market crash has an economic-based rationale or cause, but consider that there is no consensus economic rationale behind the 1987 U.S. stock market crash. So, “causeless crashes” are not unprecedented; it even happened in the U.S.
The Chinese government is intentionally pushing down its stock market valuations to prevent a bubble or to reduce the value of its currency.
Not only is this not true, but it’s also ludicrous. The Chinese government and regulators have been doing everything they can to prevent the stock markets from falling.
China is going into a recession.
I highly doubt this. Sure, the estimated Chinese GDP growth rates of about 7% in 2015, and forecasted to about 6-7% for 2016, are kind of hard to believe, but even the most skeptical economists in China still believe its GDP growth rate will be about 3% in 2016. A 3% growth rate is not great, but it’s still positive growth and beats what the U.S. has been doing lately. And a 3% GDP growth rate certainly does not put China into recession territory, especially for an economy that has already grown a lot recently.
U.S. markets heavily depend on China’s economy.
Again, not true. The amount of sales that the U.S. has in China represent a very small portion of our GDP. If you don’t believe me, then consider this… the U.S. has been complaining about its trade imbalance with China for many, many years. And if it is true, that our economy depends on theirs, then we should be happy that their currency is depreciating, as it should help their economy. The U.S. stock market simply overreacted to China’s market free-fall. We have a history of doing this. Remember when we irrationally panicked over Greece, even though the size of Greece’s economy and international trade are miniscule within the context of the global economy?
Chinese banks are going to collapse.
It is true that Chinese banks suffer from significant problems such as shadow banking. However, the Chinese government is so paranoid about this problem that I doubt it will lead to a banking collapse. The Chinese government has the U.S. to thank for this, because they saw what not-to-do as they watched us let our financial institutions and financial system crumble in 2008.
So, what is true?
Much of what I’m going to tell you here is based on my experience and accumulated knowledge and insights while in China. I moved to China in 2011, and I have been living and working in Beijing and Shanghai, mostly as a finance professor. As a researcher on China’s economy and financial markets, and also as frequent television commentator, I’ve become something of a notable economist here.
Chinese are not consuming.
The Chinese government realizes that it cannot rely on exporting forever for its country’s income and wealth, so they are trying to shift the country to move toward a greater reliance on consumption to boost their GDP. But it is simply not happening, at least not amongst the rising middle-class. This is one reason why the economy is not growing as well as it has in the past.
China curtailing its investment rates is somewhat intentional.
Many outsiders worry about China’s slowing investment growth. However, the government does not encourage investment growth for the sake of growth. This is good news. So, while declining investment rates are sort of a cause of concern, it should not be a cause of major concern.
China wants to weaken its currency, the RMB, for now.
While China is trying to find other sources of economic growth, it seems like they will keep reverting back to a reliance on exporting as they figure it out what else to do and what else will work. And a way to export successfully is to make its currency weak. This isn’t all bad. A weak Chinese RMB means China’s economy will stay healthy, which is something that everyone wants, including the U.S., but, a weak RMB also means lower U.S. export sales in China and potential for a currency war. That is, a weak Chinese currency imposes both costs and benefits on the U.S. The way the conflict will eventually shake out is uncertain, especially because the benefits of a weak Chinese currency to the U.S. is primarily indirect.
The Chinese economy will grow.
It is not a matter of if, but when, China will become the world’s largest economy. There are lots of people who criticize China’s economic policies, but consider that its transition to a market-based economy is still very much at its beginning stages. In context, China is truly remarkable in its ability to learn and in its ability to adjust quickly. My estimate is that during the next 20 years, China will contribute at least a half billion additional people to the global middle class, which is both the engine and benefit of economic growth.
The Chinese stock market’s valuations is meaningless.
As I have written before, so long as China’s accounting transparency and corporate governance are weak, we shouldn’t read too much into their stock market valuations and into its rises and falls. This is why I am often frustrated when the world takes cues from Chinese market fluctuations, as if it means anything, when in reality it means very little. Remember, the marginal investors (these are the investors that can affect stock prices) in China are uninformed, speculative, individual investors.
So, what can investors do?
I suppose this the most important question to many people, especially investors. I’ve written on this as well.
