How China’s falling stock market mirrors its failing economic policy
Chen Zhao says the repeated cycle of fiscal and monetary tightening followed by stimulus measures is largely driven by Beijing’s flawed deleveraging policy, and the drop in stock prices is just the latest phase
The Chinese stock market’s fall has finally unnerved policymakers. Securities Regulatory Commission chairman Liu Shiyu has assured investors that “spring is around the corner”, and governor Yi Gang promises that the People’s Bank of China’s toolbox is full and can deal with any risks facing the economy.
None of these statements has made a major difference, with share prices falling to fresh lows for this year. Since 2010, an economic stop-go pattern and policy flip-flops have characterised the Chinese economy: monetary and fiscal tightening often provokes undue economic weakness, forcing the government to reverse policy with a new round of policy stimulus.
Examples include draconian monetary and fiscal tightening between 2012 and 2014, leading to a sharp economic fall in 2015. The excessive weakness forced Beijing to reverse policy in 2016 by slashing interest rates and ramping up infrastructure spending. The economy recovered in 2017.
Entering 2018, Beijing reversed policy again by tightening monetary and fiscal policy, and total social financing began contracting in March. The Chinese economy has begun weakening anew, with stock prices falling sharply since January. Therefore, China’s economic problems and falling stock prices are self-inflicted.
The economy has fallen into a stop-go pattern, largely because of a flawed economic policy: deleveraging. Policymakers are concerned that ever-rising credit, standing at over 200 per cent of GDP, could be a time bomb with the potential to cause a debt crisis, destabilising the entire economic system.
As such, deleveraging has been billed as a key element of President Xi Jinping’s “supply-side reforms”, but this entire thesis is based on a flawed understanding of debt and financial intermediation.
Most Asian and European economies have bank-centric financial systems, meaning banks are the key mechanism for financial intermediation. High levels of credit creation are inherent in such a system because bank loans are key channels to transform savings into investment.
Simply put, high national savings rates usually require high levels of debt creation to transform national savings into investment, which is why Singapore, Japan and most other Asian economies have very high debt-to-GDP ratios.
China’s gross national savings rate is 45 per cent, translating into US$6 trillion of new savings each year. To intermediate such a large pool of savings into investment, China’s credit creation must stay high.
Most importantly, with the velocity of money falling off sharply around the world since 2008, it takes much more credit creation than before to intermediate the same amount of output. This means debt-to-GDP ratios have been on the rise in almost every country.
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Therefore, if the Chinese government tries to deleverage the economy by shutting off the credit supply, financial disintermediation will follow and excess savings will emerge. This could only lead to a fall in nominal GDP growth. Since 2010, China’s nominal GDP growth has followed a roller-coaster ride, largely mirroring the government’s attempts at credit tightening and subsequent monetary easing.
As for fiscal stimulus, Beijing has merely brought forward planned bond issuances to meet the funding needs of local infrastructure projects. There is little new fiscal stimulus in the pipeline. These are inadequate responses to the ongoing economic slowdown.
Cutting the reserve requirement ratio can only resolve liquidity problems in the banking system; it cannot lower borrowing costs for the whole economy. Today, China’s economy still suffers from a credit crunch, with single-A corporate bond yields well over 11 per cent. This is an extremely high cost of borrowing, especially compared with a nominal GDP growth of 9.8 per cent, and still falling.
China’s economy is facing multiple risks, and headwinds for growth could be stronger than in 2015: the US economy is expanding at a peak rate and a growth slowdown is possible. This could weaken global demand substantially, inflicting damage on China’s economy. Trump’s tariffs will undercut Chinese exports significantly for the remainder of this year and the next.
In the meantime, the Chinese central bank’s efforts to ease policy are hamstrung by the falling yuan. All this means that a stronger policy response is needed, and fiscal stimulus must be delivered in a timely, aggressive manner. Failing to act risks economic weakness and financial market instability.
The Chinese government should also abandon the outdated idea of deleveraging the economy by cutting off credit. Driving up nominal GDP growth is the most effective way to bring down the leverage ratio for an economy.
Chen Zhao is founding partner and chief global strategist at Alpine Macro. [email protected]