Global Markets Dancing on the Chinese Equities Bubble

How much is future 10 percent annual Chinese GDP growth ad infinitum a blind assumption on the part of investors? Watching the schizophrenic Shanghai equities market, I can only wonder.

According to the Chinese Communist Party (CCP), China's GDP has grown at an average rate of 10 percent a year for thirty consecutive years, with a 20 percent upward revision in 2006. Its worst year was 1998 (the year of the Asian financial crisis), when China's GDP grew "only" 3.8 percent. To put this into perspective, we can compare China's statistics with those of Western postwar economies, which had the same basic ingredients for rapid growth: extremely high marginal returns on capital (due to capital stock wiped out by WW2), and a highly educated population: a high ratio of human capital to industrial capital.

The closest comparable performance is Japan, which averaged approximately 10 percent annual growth from approximately 1957-73, dropped to 4 percent with the oil shock of 1973, and stayed at 4 percent annually through the next fifteen years. Some time after investors realized that one square mile of downtown Tokyo was priced higher than the entire state of California, the real estate bubble popped. Equities were not far behind. Japan has been mired in a period of virtually no growth and deflationary stagnation in the nearly twenty years since; the Nikkei 225 is at approximately the same level today as it was 20 years ago, before accounting for survivorship bias.

China is showing all of the same signs now as Japan did in the mid-1980's. China consumes over half of all cement in the world, and dubious public works programs have reached a fever pitch. The Chinese stock market has skyrocketed over 225% since early last year. Shanghai and Shenzhen "B" shares, which can be directy traded by international as well as domestic investors, have "appreciated" by even more.

Because Chinese people, by law, are restricted in the asset classes they can invest in, recent stock-investment deregulation has brought an avalanche of depreciating Chinese savings into the Chinese stock market. The Economist estimates that there are now over 91 million brokerage accounts in China. The Chinese government, alarmed at the political implications of millions of Chinese losing their life savings on speculation, recently tripled the transaction tax on trading stocks from .1% to .3%. Shanghai equities dropped 6.5 percent, dropped another 5 percent by noon the following day -- and smartly rebounded in the afternoon to finish the day up two percent.

The last time the Chinese government made the slightest poke at the equities bubble (by raising banks' margin requirement from 10 percent to 10.5 percent), the Shanghai index lost 8.8% of its value in a single day. That was Feb. 27, 2007.

Most governments, when they become worried about a speculative frenzy, can deal with the problem fairly easily. One, they can simply elbow the banking system into raising interest rates, making the old asset class (savings) more attractive relative to the asset being speculated to absurd heights. However, in China, that doesn't work. Nobody has any idea of the extent of Chinese banks' non-performing loans (NPLs), although estimates range from a third of Chinese GDP to over 50 percent. Again, this does not take into account "zombie loans," loans which are not losing money (so they won't have to be recalled), but which are also making no money and are thus effectively lost.

Chinese banks are terminally overloaded with debt without having to pay realistic interest rates on savings deposits. Paying depositors realistic interest rates is not an option for Chinese banks.

In more mature economies, the banking authorities can simply let the bubble pop, and let the speculators learn their lesson. But the speculative contagion has gripped tens of millions of ordinary Chinese, and a collapse in Chinese financial markets would not only significantly damage the economic standing of the CCP (its only claim to legitimacy after the catastrophic Cultural Revolution), but would also throw tens of millions of small-time day traders onto the streets of China's most densely-packed cities, in an era of flash mobs and largely unfettered communication (even in China.)

Unfortunately, short of blowing up its own banking system -- the worst of all worlds -- the CCP has no macroeconomic tools with which to curb its equities bubble. Western finance's assumption of permanently low worldwide inflation, courtesy of cheap Chinese labor, will be turned on its head. At the rate China is going, she will be lucky to get off as Japan did -- i.e., Japan's NPL-sponsored speculative mania of the 1980's led to 20 years of deflationary stagnation.