China’s Three Bubbles

The sell-off in Chinese equities accelerated Wednesday as new government efforts to arrest falling stock prices proved ineffectual. Major indices closed down six to seven percent, with shares in 72 percent of companies now unable to be traded. Beijing’s efforts to force the market upward by pumping money into the stock of large state-owned companies are failing to reassure panicked investors. As the market seizes up, the panic is spreading from margin traders to mutual fund holders. The WSJ reports:

Contagion from the plunge in Chinese stocks spread Wednesday in a sign investors within China and overseas are losing confidence in Beijing’s ability to stem the slide in the country’s equity markets and manage its economic reforms.

Shares listed on the country’s main Shanghai market dropped 5.9%, deepening a slump that has seen the market fall by nearly a third since mid-June.The gloom is no longer confined to stocks. The yield on China’s benchmark government bonds rose sharply, while investors unloaded billions worth of dollar-denominated debt issued by Chinese companies. China’s currency, the yuan, fell to a four-month low in offshore markets, while a global selloff in commodities continued, with oil down in early Asian trading and metals such as copper trading close to six-year lows.

We don’t know, and no one knows, what the Chinese market will do tomorrow or next week. This could be the Big One, the correction that deflates the whole huge China bubble of overbuilt investment that has been accumulating for years and will, after lots of pain, put the Chinese economy on an ultimately sounder basis. Or it could be just another correction on the way up to a ceiling that hasn’t yet been reached. So this may or may not be the beginning of the major economic crisis that China is bound to experience at some point in the future.

Short of that, however, it is already a political crisis—the biggest challenge President Xi Jinping has faced since coming to power. The Chinese government plays a huge role in systematically managing the country’s economy, and it has staked its legitimacy on its ability to make the economy grow. Moreover, it has taken a very clear position on the stock market crash: this shouldn’t be happening and the government will make it stop. Therefore, the government’s failure to stabilize stock prices is going to be seen as a failure of official policy. Criticism of the stock market will turn into criticism of the political leadership, and it must be said that the political leadership hasn’t demonstrated great skill in the early days of the crisis. Premier Li has allowed himself to become identified with the efforts to stabilize the stock market. If those measures succeed, he looks like a hero. But after the latest rout, a lot of people in China don’t think the policies are working.This is going to be a difficult one to ride out. China’s government claims to be able to deliver the benefits of growth along with the blessings of stability. To get growth, China has had to allow more and more market-based economic activity to take place. But in the interests of stability, and to assure faster gains than an unmanaged free market might deliver, Chinese authorities have also interfered systemically in the economy. The banking system, particular, is largely politically driven. The allocation of capital is not very efficient, and many state-owned companies have long been on life support, with banks ordered to give them the credit they need. Moreover, local governments have systematically distorted real estate markets and become dependent for their financial health on a real estate and infrastructure bubble that must be seen to be believed.So China’s extraordinary years of lending and growth have surely created an economic bubble, but they have created two other bubbles as well. First, a political bubble based in the belief that China’s government techniques can defy the laws of economic gravity and create long-term, stable, above-market rates of growth in the developing world. Second, a geopolitical bubble based on the belief that China’s stellar economic record of the last few decades will continue indefinitely into the future with immense consequences for the international order. That is, the country’s success has encouraged authoritarian regimes and technocrats all over the world to believe that markets can be managed long term, and that market forces can be indefinitely held at bay.China’s hothouse growth has been the wonder of the world. But when the Big One comes, all three of the country’s bubbles are likely to burst. For China’s authorities, their stake in their current battle with the stock market are much greater than they might appear to outsiders. This isn’t just a crisis of China’s financial markets. It is a crisis of China’s political system and international strategy.