China’s stock-mar­ket red her­ring

Financial Mirror (Cyprus) - - FRONT PAGE -

With the Shang­hai Stock Ex­change Com­pos­ite In­dex down more than 40% since last June, in­vestors world­wide are watch­ing the de­cline with grow­ing con­cern – but not be­cause they are in­vested in the plum­met­ing mar­ket (China’s stocks are over­whelm­ingly held by Chi­nese). Rather, the fear is that plung­ing equity prices mean that China’s econ­omy is go­ing down the tubes. But those seek­ing com­pelling clues about China’s eco­nomic fu­ture should look else­where.

Of course, it is true that China’s growth rate has slowed sub­stan­tially, and there are plenty of rea­sons to be­lieve that the de­cel­er­a­tion is not tem­po­rary. But none of those rea­sons has much to do with the stock mar­ket.

This dis­con­nect is ap­par­ent in the fact that mar­ket prices are higher to­day than they were in 2014, the year when China sur­passed the United States to be­come the world’s largest econ­omy (in terms of pur­chas­ing power par­ity), a de­vel­op­ment that spurred bullish ex­pec­ta­tions. What ob­servers at the time did not seem to recog­nise was that China’s econ­omy was al­ready slow­ing. Ac­cord­ing to of­fi­cial sta­tis­tics, the growth rate av­er­aged 10% in 1980-2010, but fell to 7-8% in 2012-2014.

At first, the slow­down ac­tu­ally con­trib­uted in­di­rectly to a rise in stock prices, by spurring the Peo­ple’s Bank of China to be­gin cut­ting in­ter­est rates in Novem­ber 2014. But by the spring of 2015, the mar­ket’s boom was look­ing a lot like a credit-fu­eled bub­ble. The Shang­hai in­dex peaked on June 12, when the China Se­cu­ri­ties Reg­u­la­tory Com­mis­sion tight­ened mar­gin re­quire­ments.

The truth is that China’s eco­nomic slow­down should not have sur­prised any­one. The coun­try’s three-decade run of 10% an­nual GDP growth was al­ready un­prece­dented. The ques­tion is why no coun­try, not even China, man­aged to pro­long its eco­nomic mir­a­cle? Some of­fer broad ex­pla­na­tions: coun­tries fall into the middle-in­come trap or ex­pe­ri­ence a re­gres­sion to the mean in growth rates. But, in China’s case, a num­ber of spe­cific fac­tors may be at play.

The first fac­tor is di­min­ish­ing re­turns to cap­i­tal, which weak­ened the growth-en­hanc­ing ef­fects of, say, in­vest­ment in trans­port in­fra­struc­ture and res­i­den­tial con­struc­tion. An­other is that ur­ban land prices have been bid up, while the en­vi­ron­ment’s “car­ry­ing ca­pac­ity” has been ex­hausted.

Then there are de­mo­graphic chal­lenges. The work­ing-age pop­u­la­tion has peaked, and the share of re­tire­ment-age pop­u­la­tion is ris­ing fast – not least be­cause of the coun­try’s 35-year-long one-child pol­icy, which was only re­cently re­scinded.

More­over, China’s once seem­ingly in­ex­haustible sur­plus of ru­ral labour will­ing to mi­grate to ur­ban ar­eas has largely dis­ap­peared, caus­ing wages to rise and the coun­try’s com­pet­i­tive ad­van­tage in la­bor-in­ten­sive man­u­fac­tur­ing to weaken. The econ­omy has shifted from man­u­fac­tur­ing to­ward ser­vices, where there is less scope for pro­duc­tiv­ity growth.

More­over, room for catch-up gains with the de­vel­oped economies in terms of tech­nol­ogy, pro­duc­tion pro­cesses, and man­age­ment prac­tices is shrink­ing, un­der­min­ing pro­duc­tiv­ity growth fur­ther – and leav­ing it up to China to do some in­no­vat­ing of its own.

Against this back­ground, a shift to a trend an­nual growth rate of 5-7% is nat­u­ral. But that shift can hap­pen in two ways: a soft land­ing, in which China con­tin­ues to grow at the slower-but-sus­tain­able trend rate, or a hard land­ing, in­volv­ing a fi­nan­cial cri­sis and more se­vere eco­nomic re­ces­sion.

Like Ja­pan af­ter the 1980s or South Korea in 1997-1998, China has de­pended sig­nif­i­cantly on in­vest­ment and debt fi­nanc­ing dur­ing its high-growth phase, rais­ing the risk that ex­cess ca­pac­ity could lead to fi­nan­cial cri­sis as the econ­omy slows. And, in­deed, ex­cess ca­pac­ity is al­ready a se­ri­ous prob­lem in many sec­tors.

Still, it is un­clear what kind of land­ing China faces – not least be­cause of­fi­cial sta­tis­tics may be over­stat­ing cur­rent GDP growth con­sid­er­ably. With of­fi­cial growth data usu­ally align­ing a lit­tle too closely with govern­ment tar­gets to be cred­i­ble, skep­tics are turn­ing to other, more tan­gi­ble mea­sures of eco­nomic con­di­tions, point­ing out that en­ergy con­sump­tion, freight rail­way traf­fic, and out­put of in­dus­trial prod­ucts like coal, steel, and ce­ment has slowed sharply.

Th­ese sta­tis­tics could, as many in­fer, in­di­cate that China’s econ­omy is grow­ing at a rate much lower than the 7% the govern­ment claims. But, as Ni­cholas Lardy per­sua­sively ar­gues, they could also re­flect the econ­omy’s shift from heavy man­u­fac­tur­ing to­ward ser­vices – a shift that is highly de­sir­able in help­ing China’s nat­u­ral tran­si­tion to the more sus­tain­able trend.

It is still pos­si­ble, then, that China is on track for a soft land­ing. But suc­cess pre­sup­poses less re­liance on in­vest­ment spend­ing and ex­port de­mand, and more on do­mes­tic house­hold con­sump­tion, to sup­port growth.

More­over, China must in­crease the flex­i­bil­ity of land and la­bor mar­kets. For ex­am­ple, in­se­cure land rights in the coun­try­side and the hukou (house­hold reg­is­tra­tion) sys­tem in the cities con­tinue to im­pede la­bor mo­bil­ity. More gen­er­ally, mar­kets’ role in shap­ing the econ­omy must con­tinue to grow. State-owned en­ter­prises must be reined in. The health-care, so­cial-se­cu­rity, and tax sys­tems must be re­formed and strength­ened. And bet­ter en­vi­ron­men­tal regulation is cru­cial.

Chi­nese lead­ers and econ­o­mists al­ready know all of this. They adopted a list of re­form ob­jec­tives cov­er­ing th­ese ar­eas in 2013. And in the last two years, they have made progress in im­ple­ment­ing some of them. But there is still a long way to go, and suc­cess is by no means guar­an­teed. As Shang-Jin Wei, the chief econ­o­mist of the Asian De­vel­op­ment Bank points out, progress on th­ese re­forms – not what hap­pens in the stock mar­ket – is what will de­ter­mine the fate of China’s econ­omy.

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