The great fall of China
On the eve of the Shanghai Cooperation Organisation and BRICS summits in Russia, on July 8, Xi Jinping and Vladimir Putin stood side by side, hailing the rise of new forces in the world and calling for “a more democratised” – read less American-dominated – world order. The Chinese President listed the new, ambitious economic projects backed by his government, from the $50 billion BRICS New Development Bank and the $100 billion Asian Infrastructure Investment Bank to his pet “Silk Road” initiative – a push to connect China with Central and Southeast Asia.
If Xi commanded the world’s stage in Russia, things at home were looking a lot less rosy. That same day, China’s economic planners – in the absence of the experienced central banker Zhou Xiaochuan, who was accompanying Xi in Russia – were in crisis mode. The previous day, the benchmark Shanghai Composite Index had plunged eight per cent. From a high of 5,166 on June 12, the market had fallen by as much as 32 percent, wiping out in three weeks close to $3.5 trillion – double the value of India’s entire stock market - and leaving uncertain the fate of 90 million Chinese investors.
On July 9, a panicked government unveiled the biggest intervention in the history of the Chinese stock market in a desperate effort to halt the slide: banning all IPOs, enforcing a six-month moratorium on investors selling any stakes greater than five per cent, and effectively stopping trading for more than one-third of all listed stocks accounting for 40 per cent of the market capitalization. More than that, $ 42 billion was routed through the official China Securities Finance Corporation to prop up falling stocks. The intervention seemed to halt the slide, with the market recovering by five per cent a day after the measures were introduced.
In China, the stock market hasn’t been the most accurate indicator of the health of the economy. Even the half year-long bull-run before July’s crash defied every indicator suggesting a slowing economy. Yet the crash exposed starkly the frailties of China’s financial sector. Stymied by artificially low interest rates, Chinese investors – from big businesses to small-time individual investors – flocked to a stock market often dubbed “a casino”. The boom was fuelled by out-of-control margin trading – borrowing money to buy stock – which finally prompted the government to intervene. A spooked market then panicked, triggering the crash.
Chinese economists say the crash of a market that has often been seen as irrelevant to the fate of the larger Chinese economy may not weigh down the world's second-largest economy. “Fluctuations do not mean fundamentals of Chinese economy are not good.” says Xing Houyuan, Deputy Director of the Research Institute run by China’s Ministry of Commerce. Yet the ripple effects could pose new obstacles for an already strained Chinese economy. Concerns are that a banking sector already grappling with a massive local government debt problem could face further stress – economists suspect that a lot of the margin trading was funded by risky wealth products offered by banks. The government intervention to prop up the crashing stock market has further dented the credibility of the market at a time when Beijing was hoping to introduce a slew of financial reforms to open up debt-laden State-run enterprises.
For India, the impact of a prolonged Chinese slowdown presents a mixed picture, economists in Beijing and New Delhi say. On the one hand, a slowdown in China could rid the world of excess manufacturing capacity and falling commodity prices on account of a slump in Chinese demand could benefit countries like India. Foreign investors spooked by the Chinese slowdown may also turn elsewhere. On the other hand, there are a range of worrying ripple effects. As industry group Assocham warned in a July 12 paper, Indian iron ore and steel producers who have been reliant on Chinese demand to push up prices are already feeling the pinch. Supply chains reliant on Chinese machinery and equipment, especially in the power and infrastructure sectors, could face the risk of disruptions at a time of expansion.
Boom and bust
In China, the crash has raised fresh questions about how the world's second-largest economy will manage its slowdown. “The bull market was a classic asset bubble,” said Oliver Rui, Director of the CEIBS-World Bank China Centre for Inclusive Finance Professor of Finance. “Most of the stocks were overvalued. The bull market was created by government stimulus and investor frenzy. Unfortunately highly-leveraged greedy individual investors hijacked this initiative. It was a casino mentality.”
In November, the benchmark Shanghai Composite Index was at a lowly 2,400 points. Towards the end of last year, the government began pushing State-owned Enterprises (SOEs), saddled with debt, to raise funds from the market as part of reforms unleashed by President Xi Jinping to make the state sector more efficient. This government-encouraged boost for the stock market, coupled with curbs on housing purchases to cool the real estate sector amid fears of a bubble, led to a rush of new investors.
Investors like Amber Deng, fresh out of university, who bought her first stocks in February. She approached a trading firm in Haikou, the capital of China’s southern island province of Hainan, and used up most of her university scholarship to make her first trade. Putting her money in banks, Deng reasoned, was a losing proposition: State-controlled interest rates were extremely unattractive, while proposed interest rate liberalisation reforms lay in cold storage.
That month, Deng was only one among more several million Chinese who became first time investors. Over the past year, the number of investors in China’s stock market soared, reaching 90 million – more than the number of members in the Chinese Communist Party. Of them, close to 85 per cent were small-time investors like Deng with account balances of less than 100,000 RMB (Rs. 10 lakh). She was, however, a minority in having a college degree: 94 per cent of those who joined the market, from retirees to farmers, did not.
“Every day, the media would list stocks and suggest people buy them,” said Li Lingmin, another first-time investor, and graduate of Beijing Normal University’s campus in Zhuhai, who started trading in March. “It is something about human greed and desire. When you see people around you play the market all day long and they all make money, you have the desire to join in.” The bull-run became self-fulfilling. The Shanghai index soared as more people joined the gold rush – many taking out high-interest loans to buy stock – more than doubling the entire value of the stock market in five months. By June 12, the Shanghai index was at 5,166. Worried by out-of-control borrowing to buy more stocks, the government stepped in. “As the government began to deleverage the margin trading, the whole market began rushing for the exits,” said Rui.
For the Communist Party, the crash was a big blow - the first real challenge for the Xi Jinping administration. The bull-run had, after all, been spun by the official media, despite clear indicators of a slowing down economy, of Chinese exceptionalism amid global difficulties. For a stability-obsessed one-party state, the fate of 90 million investors, from college graduates like Deng to retirees investing their pensions, was not something to be taken lightly, prompting the rapid intervention.
While the government may have halted the slide, analysts warn that the intervention will dent the credibility of a market often derided as “a casino”. "If the government does not let the market play a decisive role in asset allocation," says Rui, "this kind of incident will happen again. Any stock market is built on the confidence and expectations of the future. I believe the current measures are not sufficient to rebuild market confidence." The longer term concern is a spillover to China’s financial system, which is already dealing with the problem of massive local government debt – a legacy of uncontrolled infrastructure spending following the $586 billion stimulus plan of 2009. “If the market is not quickly calmed,” adds Rui, “the pessimistic sentiments will spill over to the banking sector, and eventually it could affect the real economy. Some insiders believe a significant portion of capital used for margin trading actually comes from the asset management products issued by the banks. Some also believe that some entrepreneurs have invested in the stock market using operating capital.”
What will a prolonged Chinese slowdown mean for India? Economist Arvind Virmani, formerly Chief Economic Advisor and India’s representative at the IMF, says the effect will be “net positive”. “China's investment led growth model has continued to create manufacturing capacity for the world despite a fall in global demand, putting downward pressure on prices and profits across the world. A collapse of China investment will restore supply-demand balance faster,” he says.
Not everyone agrees. In a July 12 paper, industry group Assocham listed the domino effects of a Chinese slowdown that would hurt India, from metal and iron ore producers, who have been reliant on Chinese demand to push up prices, to imports that are crucial to supply chains. The paper also cautioned that a slowdown in China would not automatically make India a preferred destination for foreign investors: “Even in the stock markets, it would be too simplistic an assessment to suggest that the global portfolio investors would shift their funds from China and invest in India. Each dollar that will come to India will come because of its own merit and not due to weaknesses in China or elsewhere”.
There is also the prospect of China moving to export its overcapacity problem, not just in steel but in a range of sluggish sectors including renewables. In the first half of this year, Chinese steel exports were up a record 30 per cent amid a slowdown at home. This is part of the motivation for Xi Jinping’s ambitious $100 billion “Silk Road” initiative. “We will upgrade our technology and industrial capacity so that we will transform our economic growth model, and at the same time transfer some competitive production capacity to countries along the Silk Road,” says Xing of the Commerce Ministry think-tank.
In 2014, India imported $54 billion worth of goods from China – more than any other country – the bulk of which was heavy machinery and power equipment. “The kind of cost competitiveness which the Chinese companies provide to several manufacturing, semi-process industries like electronics, electrical, telecom equipment, will go missing from the global supply chain,” warns the Assocham paper. The more immediate impact will be on the steel industry. Sluggish growth in China over the past 12 months has been most felt on the Chinese steel industry, where the government is struggling to deal with an overcapacity problem. Steel consumption last year fell for the first time in 14 years, following a decade where China’s voracious appetite for iron ore and other minerals saw iron ore prices jump five-fold to more than US $200 per ton. Today, that has fallen below US $70. In India, Chinese demand fuelled a mining boom – including a sprawling illegal mining industry that the government has clamped down on with the closure of mines in Goa and Orissa – while high prices were a boon to India’s heavily indebted steel producers.
However, with falling prices because of the slump in Chinese demand, the Indian steel sector will likely be badly hit. “Even if India's steel demand growth rises eventually,” says a July 7 Credit Suisse report on the steel sector, “pricing and profits are still linked to global trends”. Some bankruptcies, it warns, will be unavoidable. As China's appetite continues to slow, the fall in iron ore, steel and copper prices will further hit Indian manufacturers. For them, at least, the slowdown across the border has been little cause for cheer.