Photograph by Getty Images
By Stephen S. Roach
July 10, 2015

The Chinese equity bubble has obviously burst – with enormous consequences for China and the rest of the world. At the close on Wednesday, the CSI 300 – a composite index of major shares trading on the Shanghai and Shenzhen exchanges – had plunged 31% from its June 12 peak following a near vertical run-up over the previous 7 months. Notwithstanding massive government support actions that have driven a partially closed market up 12% July 9-10, there’s no telling where the market finds a bottom.

This had all the ingredients of a classic asset bubble. After underperforming other major equity markets for six years, the Chinese stock market started to come to life in the second half of 2014 as the government moved to stimulate a slowing economy. It then took off like a rocket ship immediately after the November 17, 2014 launch of the Hong Kong-Shanghai connect – an arrangement allowing investors in both markets to trade overlapping shares. Fully 87% of the spectacular 145% surge in the 12 months ending June 12 occurred after the cross-border connection was opened.

As is typically the case in other asset bubbles, Chinese market regulators lacked discipline during the blow-out phase of this bubble. Indeed, this speculative frenzy was fueled by an equally potent surge of margin financing, which nearly trebled as a share of tradable equity market capitalization in the 12 months ending this June. Meanwhile, an overhang of excess supply was building, as security regulators approved a sharply increased volume of initial public offerings in the first half of 2015. And leading Chinese officials expressed encouraging signs of support for this apparent renaissance in equity financing.

Asset bubbles invariably burst under their own weight. China’s implosion over the past month is no different. The key questions pertain less to the potential downside of the market – impossible to know – and more to the ultimate impact on the real economy, which is at a critical juncture on the road to reform and rebalancing.

China’s retail investors will certainly feel the brunt of the carnage. There appear to be some 90 million of them – roughly 12% of the nation’s urban population. Data from China’s Household Finance Survey suggest that these investors tend to be young and relatively uneducated. In 2014, a majority of new investors didn’t even have a high school education! And with approximately 1 and 2 million new accounts being opened per week in the first half of 2015, according to the China Securities Depository and Clearing Co., these are very inexperienced investors. Add to that, their penchant for buying stocks on margin, and there can be no escaping the devastation to speculators that invariably follows the bursting of any bubble.

In the same sense, it would be wrong to generalize on the basis of this vulnerable 12% of the urban population. Indeed, there is an important silver lining to China’s unbalanced economy that should limit the damage. The bursting of equity bubbles impacts shareowners, or consumers, in the real economy through what economists call “wealth effects” – in essence, the capital gains and losses (both real and psychological) that stem from the ups and downs in the stock market. Yet China’s private consumption is only about 36% of its GDP – well below shares of more advanced nations. If China had a more balanced economy – something it clearly aspires to – then a larger consumer sector would have raised the possibility of much greater macro risk in the face of a post-equity bubble implosion. Fortuitously, that is not the case for China in 2015.

A comparison with the United States is especially pertinent. Prior to the Great Crisis of 2008-09, personal consumption was nearly 70% of U.S. GDP – essentially double the portion in China. Moreover, consumers were heavily levered – borrowing freely from a massive property bubble to support consumption. When the twin bubble burst – both property and credit – American consumers went into a wrenching balance sheet recession, which endures to this day. The annualized growth of real consumer expenditures has averaged just 1.4% over the past seven years – down sharply from the 3.6% trend in the 12 years before the crisis and, in fact, the weakest period of consumption growth since the 1930s.

What this comparison means is that the downside risk to the Chinese economy in the aftermath of the bursting of its equity bubble is likely to be far less severe than that which has occurred in other post-bubble economies – notably Japan and the United States. This is very much at odds with the fears that have been expressed in many quarters that China’s equity market implosion portends a hard landing for the world’s second largest economy.

Nevertheless, the sharp decline in Chinese equities should not be taken lightly. Asset bubbles, which have occurred all too frequently around the world over the past 25 years, can pose a severe threat to real economic activity. There are several examples of this in just the past quarter of a century. First it was Japan with its property and equity bubbles, then America with its dotcom, property and credit bubbles, and of course Europe with its “convergence bubble” that saw artificial growth in Southern Europe and Ireland stemming from an interest rate convergence play. China needs to be mindful of three important lessons from these earlier experiences:

First, while it is impossible to avoid the cycles of fear and greed that have given rise to speculative asset bubbles for centuries, regulators and policymakers must draw the line when bubbles threaten to distort the real economy. Fortunately, as stressed above, China’s embryonic consumer sector works to its advantage in this key respect. However, some day – after rebalancing occurs – that will not be the case. China certainly needs to prepare for that eventuality.

Second, bubbles and the policy responses they evoke, are a serious threat to financial stability. For China, the bursting of its equity bubble not only poses a risk to financial stability but it also draws into serious question efforts to wean Chinese companies from bank-centric financing strategies by enticing them into the presumed security of the equity market. As such, the bubble, and the instability it underscores, is a major setback on the road to capital market reform – a linchpin of China’s rebalancing strategy. The good news is that Chinese authorities still have plenty of ammunition left to deal with the fallout from a plunging equity market – in sharp contrast to major economies in the developed world, which are stuck in liquidity traps at zero interest rates.

Third, this time is not different. Regulators and policymakers must avoid the seductive temptation of believing that surging markets are validating a new approach to economic management and development. A seven-month doubling of the Chinese equity market was, in retrospect, an accident waiting to happen. It was a time for discipline – not complacency.

Chinese authorities are obviously taking this problem very seriously. It remains to be seen if the wide-ranging actions now being initiated will be sufficient to arrest the decline. That day will eventually come – hopefully sooner rather than later. When the dust settles, it will be time for a careful retrospective examination of what happened and why. China can ill afford to make the same mistake twice.

Stephen S. Roach, a faculty member at Yale University and former Chairman of Morgan Stanley Asia, is the author of Unbalanced: The Codependency of America and China.

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