China is only delaying the deluge

In November 2013, the Chinese Communist Party Third Plenum declared that market forces would play a 'decisive role' in the Chinese economy. This was seen at the time as evidence that China was indeed moving away from its state-led growth model, and on the road to reforming its economy from an investment led economy to a consumption based one. For many years now, China has misallocated resources on a gargantuan scale, ranging from projects like the ghost city of Ordos in Inner Mongolia, to the Yujiapu district in Tianjin.

One of the ways the Chinese government set about overcoming this reliance on state-led investment was by encouraging its citizens, through the official Xinhua newsagency, to invest in the stock market. Ordinary Chinese, who suffer from low deposit rates in a financially repressed system, reacted accordingly by pouring enormous amounts of money into the stock market. Whilst this led to an enormous rise in both the Shanghai and Shenzhen stock exchanges, it nevertheless created a massive equity bubble which burst.

From June 12^th to July 2nd the Chinese stock market lost over $3 trillion. Instead of letting 'market forces' play a decisive role, the Chinese authorities instead panicked and intervened, forbidding the selling of stocks by those who hold more than 5% market share to stop selling and literally ordering that state-run institutions buy shares. Once again, the Chinese leadership has demonstrated that whilst it may speak the rhetoric of allowing market forces to play a decisive role, it balked when the self-correcting mechanisms of the market punished those who had invested poorly.

Why is this potentially dangerous? And why should we worry? Although it is true that the stock market is only a small percentage of the Chinese economy as a whole, this is dangerous for a number of reasons. Firstly it sends the wrong signal to potential investors - namely that Beijing stands behind the stock market, and will move to prop it up if it falls below a certain threshold level. This is akin to the 'Greenspan Put,' which occurred when former Federal Reserve Chairman Alan Greenspan continually lowered the federal funds rate, injecting liquidity into the U.S market whenever a stock crisis occurred.

Greenspan's actions created a perverse set of incentives for investors, who subsequently engaged in ever riskier stock speculations. Ultimately Greenspan's policy was partly responsible for the US Subprime disaster of 2008.

In China's case, Beijing's actions show that it is very frightened of the consequences of a financial crisis - it has even gone so far as to put a ban on 'malicious' short sellers, and has even allowed the borrowing of money against real estate to fund stock purchases. However, if the fundamentals of an economy do not support the valuations of a stock exchange, then all Beijing is doing is throwing good money after bad.

This then begets a second problem-namely that no government, not even Beijing, has limitless amounts of money to waste. China's debt quadrupled from $7 trillion in 2007 to $28 trillion by 2014, an expansion in debt that exceeds anything ever seen before. What is just as worrying is that an enormous amount of those loans are likely to be non-performing, resulting in massive losses in the Chinese banking system. Sooner or later, Beijing's capacity to add more debt will cease and a debt crisis will occur.

By not taking the pain now, Beijing is instead potentially sowing the seeds for an even more massive crisis in the future. A whole generation of Chinese has never lived through an economic downturn, and it is not certain how politically stable China would be in the event of a crisis. It should be noted that in 2010 China was estimated to have had 180,000 'incidents' per year-- protests, riots and mass demonstrations-- a four-fold increase from 2000. This increase in unrest has occurred when GDP has been rising, and the Communist Party would be even more worried if the economy were to truly falter. Indeed, the Tiananmen Square protests were in part provoked by a worsening of economic conditions circa 1989. It should be noted that China's leaders take the possibility of a revolution much more seriously than outsiders think-indeed so much so that China spends more on internal security than on its military. Furthermore it was hyperinflation in the late 1940s that was the final nail in the coffin for the former ruling Nationalist Party. A politically unstable China is not beyond the realm of possibility and would pose enormous security challenges for our region.

An economic crisis in China is potentially very worrisome for another reason, namely that the world has not fully recovered from the Global Financial Crisis and can ill afford another major shock. It must be noted that despite all the attention that was given to the current situation involving Greece, the Greek economy is much less important to the health of the world economy than the Chinese economy.

This is worrisome to Australia, firstly because China is Australia's largest trading partner and has been the principle contributor to our mineral resources boom. There has already been a lay-off of workers in the mining sector due to the slowing Chinese economy. A major slowdown in China would almost certainly tip Australia into recession.

It is to be hoped that the Chinese government heeds its own advice and indeed allows market forces to play a more decisive role. The longer China delays, the harder the eventual landing will be.