The Chinese stock market, as measured by the Shanghai Composite Index, crashed 6.9% on Monday January 4, 2016, triggering circuit breakers that shut down the market. This weakness spilled over into other global financial markets resulting in a 1.5% loss for the Standard and Poor’s 500 Index on the first day of trading in the New Year. What caused this violent downside move in Chinese stocks and how concerned should investors be?
One of the catalysts blamed for the weakness was a report that Chinese manufacturing activity declined for the 10th straight month in December. A bigger issue, not discussed as much, is the rate of credit (debt) growth in China. Since 2007, China’s total debt has quadrupled, growing from $7 trillion to $28 trillion. At 282 percent of Gross Domestic Product (GDP), China’s debt as a share of GDP is larger than that of Germany or the U.S. While this ballooning debt has helped fuel China’s economy over the last several years, it is also suspected to have resulted in a fair amount of mal-investment, or investment in projects that have very little, if any, long-term economic value. The Chinese authorities are attempting to rebalance their economy away from an almost purely infrastructure/manufacturing based economy to a more consumption/services based one. All the while attempting to continue to keep GDP growing at 7%. The Chinese authorities know full well the risk of a pronounced economic slowdown that risks a credit crisis, given the buildup of debt, similar to the one experienced in the West in 2008. Therefore, they will likely continue to resort to very aggressive measures to stimulate economic growth and prop-up their stock market. Will they be successful, and is it a cause for concern? The answer as to whether they will succeed is unknowable, but history suggests a rate of credit growth of this magnitude greatly increases the probability of a credit crisis. And given that the Chinese economy is the second largest in the world, the answer as to whether this is cause for concern is a definitive yes. The interconnectedness of global financial markets has never been higher and what happens in China is likely to affect asset prices globally, including here in the U.S.