After a horrible few weeks, the composite index of China’s two stockmarkets has fallen more than 40 per cent since mid-June.
Anxious investors are asking whether we are seeing the beginnings of a Lehman Brothers moment with Chinese characteristics, a reference to the collapse of the investment bank in September 2008 after the US government refused to bail it out.
This subsequently led to the largest bankruptcy case filed in US corporate history, followed by a global financial crisis from which advanced economies are only just recovering.
From 2008 onward, China kept on growing while the world economy slowed. It achieved this apparent miracle through the largest fixed-investment or capital building program the world has seen.
If the story of extreme debt-driven expansion tends to end badly for most economies, how it plays out and where these economies end up are not always the same.
The better news is that China is unlikely to suffer a Lehman Brothers moment. The bad news is that its future will probably more resemble a stagnating Japan of the 1990s, but with ramifications far worse for the Chinese people and possibly their government than it was for the Japanese.
On the face of it, the wild stockmarket ride in China tells us little about how the economy is actually going because stock prices in the country bear no resemblance to economic reality. In the couple of years leading up to the big falls from June onward, the index of stock prices was ambling along at a moderate pace before suddenly jumping 140 per cent in the eight months up to the middle of this year. This occurred as the Chinese economy was growing at its slowest pace for 15 years, and corporate profits were at their poorest since the late 1990s.
How did the Chinese stock exchange become the country’s favoured casino in the first place? The problem comes down to too much easy capital chasing too few worthwhile investments.
When the GFC devastated China’s major export markets in North America and Europe, the Communist Party responded with the largest monetary stimulus policy in economic history. From 2008 to last year, $US15 trillion of new capital was injected into the economy, a figure that equates to about 1½ times the size of the entire US commercial banking system.
Credit came initially from state-owned banks, then increasingly via the unregulated shadow-banking sector that is now behind around half of all lending in the country. The latter refers to all unregulated and/or off-balance sheet offered by banks and other lending institutions. In just the past six years, the country’s total debt as a percentage of gross domestic product has increased from a manageable 150 per cent to almost 300 per cent, a pace of growth that exceeds what occurred in the US in the run-up to the Lehman Brothers collapse.
Up to one-third of the new capital investments in the first six years of the stimulus period went into building residential housing, even if many of them remain unoccupied, with existing empty lots able to house the expected increase in urbanisation for the next two decades.
Predictably, speculators including households and local government entities borrowed trillions of dollars from the formal and shadow banking system to speculate on residential property to make a quick profit.
When Beijing moved to restrict investor speculation in real estate, fearing a bursting of the property bubble and all that would entail, speculators began shifting their focus to the stockmarket. In the five years before 2015, an average of about 120,000 new broking accounts were opened each week. By March this year the number of new accounts opened a week reached an astounding 4.5 million.
About the same time, the median price-to-earnings ratio of listed Chinese stocks increased from less than nine times at the beginning of last year to almost 80 times earnings in June this year.
And as we know about any rapid rise in stock prices facilitated by a highly leveraged and loose credit environment, speculative greed eventually gives way to panic and fear.
As economic history shows, the combination of creative accounting, growth based on heavily leveraged debt and ploughing too much capital into unworthy projects is a sure step towards financial and economic ruin. Even so, the really hard part is working out what a serious and sustained Chinese slump looks like.
The good news is that China can probably avoid a Lehman Brothers moment. Back then, intra-banking lending ground to a halt after commercial banks lost confidence in the solvency of each other after the collapse of the financial giant.
Liquidity in the economy subsequently dried up as banks treated each other as failing institutions and almost created a self-fulfilling prophesy.
China’s financial system is very different. The system is dominated by state-owned banks that ultimately do what Beijing tells them to do. This has been proven time and again in that Beijing has frequently forced banks to lend to other financial institutions and firms when authorities demand more liquidity in the system. In addition to a largely closed capital account that restricts money flowing out of the country even when the economy is in obvious distress, the government has a large pool of domestic savings from which to draw in the coffers of state-owned banks.
Such a perverse resilience in terms of guaranteeing liquidity comes at a cost. Beijing may boast that it has many tools with which to combat the slowdown, a sentiment repeated several times by Joe Hockey as an article of faith. But its policy weapons — such as forcing banks to lend, lowering interest rates or reserve requirements of lending institutions, to name several — come down to essentially the same poison: increasing the flow of artificially cheap credit into the economy to soften or delay a slowdown.
The problem is that throwing new capital into even more wasteful projects, which in turn are used as collateral for further borrowing, guarantees a fall from a higher place in the future when bad loans eventually are written off.
Additionally, debt in the Chinese economy is already so high that every one in three dollars of new borrowings is now used to manage existing debt in the form of paying off interest obligations or the principal of original loan.
The bottom line is that while China can throw more new money into the system, it is getting less and less bang for each buck. And this is the same dynamic that turned the Japanese miracle of the 80s into the moribund economy of the 90s and earlier this century.
If China is indeed repeating Japanese mistakes, it does not have the latter’s preparedness when the slowdown took hold. As a visiting politician from England’s north famously remarked when visiting Japan early this century, “If this is a recession, I want one.”
By the 90s, Japan had grown rich before becoming old. It had a world class and adequately financed pension system in place, and a generous welfare system and good social safety nets by Asian standards. The stability of its political system was no longer dependent on government guarantees of economic growth.
And Tokyo felt little need to challenge the strategic or territorial status quo in the region by pouring a huge proportion of the fiscal budget into the military.
In contrast, China has none of these accomplishments, few of the same graces, and remains an ageing society and fragile authoritarian political system dependent on a failing model of economic growth.
In short, we have no clear idea of where any of this is heading, and neither does Beijing.