“China has a major adjustment problem,” George Soros told a conference in Sri Lanka on Thursday. “I would say it amounts to a crisis. When I look at the financial markets, there is a serious challenge which reminds me of the crisis we had in 2008.”
Soros is wrong on one important count. The next global downturn, which looks like it is now beginning in China, will be worse than the one last decade.
Last week, China shook. Twice—Monday and Thursday—a just-installed “circuit breaker” mechanism, designed to limit volatility, caused Chinese stocks to crash. All of the market gains last year were wiped away in just four trading sessions. By Thursday, the widely followed Shanghai Composite Index lost 11.7 percent, while the Shenzhen Composite was off 15.2 percent. That meant the destruction of about $1.1 trillion in wealth.
Friday, Chinese stocks managed a “relief rally,” as Claudio Piron of Bank of America Merrill Lynch termed it in comments made to CNBC. Shanghai shares climbed 2 percent while Shenzhen rose 1.1 percent.
Nobody expects stocks to continue their upward path, however. “I think the impact should be short-lived, a couple of days maybe,” Piron predicted.
And why is that? As Peter Boockvar of The Lindsey Group, an economic advisory firm, said to CNN, “China’s stock market is going to go where it’s going to go.”
And China’s market wants to go down. The only reason for the rally Friday is that China’s “National Team” of state and state-controlled entities bought up shares in a bid to restore confidence.
Money is gushing out of the country, in fact, a sure sign the Chinese people are losing confidence. That is why relatively unimportant news could trigger such widespread selling. The New York Times’s Paul Krugman on Friday wrote that the data out of China does not appear to be “big enough” to trigger a worldwide crisis, but he worries about the transmission of panic to global markets.
He should. On Monday, what was predictable reporting about the Chinese manufacturing sector led to a 300-point initial drop in the Dow after causing losses in Asia and Europe. On Thursday, a long-forecasted decrease in the value of the renminbi, the Chinese currency, was the main factor in an almost 400-point tumble at the close of trading in New York.
The markets still do not understand China. The financial community has accepted too much of the Chinese government’s line on its economy, and traders have not discounted the severity of the downturn that will almost certainly take place there. So just imagine what happens to global markets when distressing news out of China gets really dramatic.
If China were to fall apart at any other time, the contagion that Krugman worries about could be limited. At the moment, however, the world economy is vulnerable, with growth a concern almost everywhere but Africa. Moreover, the post-war international system looks fragile, with Russia redrawing borders in Europe by force, with China grabbing the waters of the South China Sea, with North Korea detonating nuclear weapons it is not supposed to have, and with another round of violence in the Middle East.
The investment community has vastly overestimated China’s contribution to the global economy and significantly underestimated its fundamental problems. A little ignorance can go a long way in bringing on history’s next great downturn.
Here’s how we came to this distressing pass.
China’s technocratic leaders recklessly created a stock market boom in the latter half of 2014 by talking up the prospects for shares. They succeeded in raising prices until the middle of June of last year, when the market started to collapse. Beijing, beginning in early July, triggered a rebound with a determined effort that included the buying of stocks by the National Team, the intimidation of market participants with threats and detentions, and the criminalization of various forms of selling.
Chinese technocrats saved prices, but in the process they ultimately froze the markets. Activity fell dramatically. For instance, as a result of Beijing’s tactics, the volume in China’s stock-index futures market, once the world’s largest, plummeted 99 percent in the June-to-September period. Stock trading volume fell by around 70 percent.
In November, it looked like China’s technocrats were trying to return the markets to normal operation by loosening restrictions. For instance, they announced the resumption of initial public offerings. Investors, however, perceived the rollback of controls as an opportunity to sell off shares.
What triggered Monday’s sell-off was the release of the Caixin/Markit Purchasing Managers’ Index, which showed that China’s manufacturing sector contracted for the 10th-straight month in December. The continued weakness in this private survey, in stark contrast with robust official numbers for industrial output, is a hint that the overall economy is expanding only in the low single digits.
There is now wide disagreement over the performance of the economy. The official National Bureau of Statistics reported that growth in the third calendar quarter of last year was 6.9 percent, and Citigroup’s chief economist has said China is generally growing around 4 percent. People in Beijing were privately talking 2.2 percent in the middle of last year, when the economy was doing better than it is now. Whatever the real number—and no one truly knows what it is—it’s clear it is falling. More important, it’s also evident Beijing no longer has the ability to reverse the downward trajectory.
There have been six reductions in benchmark interest rates since November 2014 and five reductions of the bank reserve-requirement ratio since last February, but this monetary stimulus has had no noticeable effect, largely because there is a lack of demand for money. Central government technocrats have doggedly created cash—M2, the broad gauge of money supply, was up a 17-month high of 13.7 percent in November—but there is, after a prolonged period of overbuilding, little need for it.
Fiscal spending, a good measure of the government’s overall stimulus efforts, accelerated as 2015 wore on. It was up 25.9 percent in August, 26.9 percent in September, 36.1 percent in October, and 25.9 percent in November. Nonetheless, growth has continued to erode as spending skyrocketed.
All this additional cash is not avoiding what looks like economic failure. Imports, a good indication of both manufacturing and consumption trends, fell 8.7 percent in November in dollar terms, a record 13 straight months of decline. Exports that month were off 6.8 percent, the fifth-straight month in negative territory. China’s links with the world economy, therefore, are in decline.
Another disturbing sign comes from price data. China’s nominal GDP growth of 6.2 percent in the third calendar quarter of last year was less than the officially reported real growth of 6.9 percent. China, therefore, has entered a deflationary period. Deflation, in turn, suggests a 1930s-style depression. The country is already staggering under excessive debt, perhaps as much as 350 percent of gross domestic product. Debt of that magnitude becomes almost impossible to service in an era of continually declining prices.
The best-case scenario for China is decades of recession or recession-like stagnation. And that is why money is fleeing the country at the moment. Bloomberg reports that there was $461 billion of net capital outflow in the third quarter of last year. In the fourth quarter, there was a $367 billion outflow. The decline from the third to fourth quarter was attributable not to an improvement in sentiment but the imposition of informal, off-the-books capital controls.
These impediments to movement of capital never work in the long term because people always find a way around them, and that is surely what happened last quarter. Why do we suspect this? During that quarter the declines in the country’s foreign exchange reserves steadily increased. In December, the reserves fell by a record $107.9 billion.
What’s the best economic indicator? That’s the flow of capital. The Chinese are taking money out of their country as fast as they can, telling us China does not have much of a future.