China: Uncharted territory Global Economic Outlook, Q3 2015

After a lingering slowdown, the Chinese economy has begun to show some signs of possibly bottoming out. The country is in the midst of an equity market boom—or possibly a bubble.

Economic conditions

After a lingering slowdown, the Chinese economy has begun to show some signs of possibly bottoming out. The government reports that several indicators improved in May, suggesting that the central bank’s three recent interest rate reductions might finally be bearing fruit. However, there are some negative signs as well. Here is what we know:

  • Industrial production increased 6.1 percent in May vs. a year earlier, an improvement from the 5.9 percent gain in April.1
  • Retail sales increased 10.1 percent in May, slightly better than the 10.0 percent increase in April.2
  • Fixed asset investment was up 11.4 percent in the first five months of the year vs. a year earlier, a bit slower than the 12 percent gain for the first four months of the year.3 Decelerating investment is not necessarily a bad thing, as China desperately needs to shift away from investment-driven growth and toward consumer-driven growth.
  • Credit creation accelerated in May vs. April, indicating that the easing of monetary policy is having a positive effect. On the other hand, we do know that much credit expansion has been channeled into the frothy equity market, which continues to exhibit the attributes of a speculative bubble.4 Given excess capacity in housing and heavy industry, the easing of credit conditions may boost asset prices rather than investment.
  • After a first-quarter slump, housing sales rose 5.1 percent in the first five months of 2015 vs. a year earlier—still a slow pace but potentially encouraging: It appears that the easing of mortgage market regulations is having a positive impact on housing activity, which may help to stabilize housing prices.
  • Inflation eased in May. The consumer price index was up 1.2 percent in May vs. a year earlier, slower than in April. Consumer prices were down 0.2 percent from April to May, the third consecutive month of declining prices. In addition, producer prices were down 4.6 percent in May vs. a year earlier. All this means that the excess capacity in industry continues to be a problem.5

The one unambiguously negative batch of economic data concerns trade. China’s imports declined sharply in May, down 17.6 percent from a year earlier and even bigger than the 16.2 percent decline in April. This decline is seen as reflecting deteriorating domestic demand and evidence of further economic weakening. Indeed, imports of iron ore fell sharply, indicating weak plans for investment in infrastructure and construction. It may also reflect weak export demand because many imports into China are reprocessed into exportable products. Indeed, May exports were down 2.5 percent from a year earlier. The result was a widening of China’s trade surplus. Exports to the United States were up 7.8 percent, while exports to the European Union were down 6.9 percent. The Chinese currency has risen considerably in value against the euro, which partly explains the weak exports to Europe. The poor trade numbers for both April and May bode poorly for GDP growth in the second quarter—and increase the likelihood that the government will soon take new measures to stimulate a relatively moribund economy.6

Equity bubble and potential problems


China is in the midst of an equity market boom—or possibly a bubble—with prices on the Shanghai Exchange up more than 120 percent from a year ago. Moreover, the amount of money traded each day has increased commensurately, providing further evidence that this might be a bubble. Yet not everyone is convinced: Some people have noted that the price-earnings ratio of Shanghai listed stocks is not especially high and is well below the ratio seen during China’s last stock market surge in 2007—which ended in a massive rout. Still, the amount of money traded now is far higher than in 2007; moreover, much of the money traded today is borrowed. Until recently, much of that money was going into the property market. Yet with huge excess capacity in that market, investors are shifting their demand to equities, adding risk to the financial system.



A debate is emerging about the possible consequences of a bursting of China’s frothy equity market bubble­—if and when it eventually comes.

The surge in share prices has been largely fueled by loans to margin traders. Millions of ordinary citizens, many without formal education, have flooded the equity market to take advantage of the boom. This came despite a slowdown in China’s economy, excess capacity in industry leading to declining wholesale prices and weaker profit margins, and a cutback in investment growth and growing capital outflows. In other words, the equity market boom has defied logic—a hallmark of an unsustainable bubble. In any event, a January decision by brokerages to crack down on margin trading may reflect pressure from concerned regulators. A recent drop in prices, if sustained, could lead more investors to sell in an attempt to secure the profits they have made. A further drop in share prices would likely lead to margin calls, creating a vicious cycle of declining prices and share redemptions. Ultimately, many investors could find themselves unable to service the debts they have accumulated, thus leading to sizable losses for the banks that have extended credit to brokerages. One irony of this situation is that China’s central bank has been easing monetary policy in order to boost credit market activity and revive economic growth. Yet rather than fueling investments in tangible assets, for which there is already excess supply, the easier monetary policy appears to have contributed to an asset price bubble.

A debate is emerging about the possible consequences of a bursting of China’s frothy equity market bubble—if and when it eventually comes. Some analysts worry that, because debt financed so much of the recent increase in share prices, a reversal of share prices would lead to financial troubles for a large number of households, as well as for some banks. On the other hand, other analysts note that equity market capitalization remains a relatively low share of GDP compared with developed economies. And while share ownership has increased considerably, it remains a low share of total household net worth. Therefore, the consequences of a drop in share prices would be manageable. In addition, given the government’s penchant for intervening in the market, it is possible that the government would attempt to ease the impact of an equity market collapse by injecting liquidity into the market. The reality is that the current situation is new territory for China, and the impact of a sudden reversal of equity prices is hard to foresee.

Currency valuation issues

For much of the past two decades, China’s central bank purchased foreign currency in order to suppress the value of its currency, with the goal of maintaining the competitiveness of its manufactured exports. This was successful in driving economic growth through exports; it also led China to accumulate the world’s largest bundle of foreign currency reserves. Yet it also resulted in complaints from other countries, especially the United States, that China was manipulating its currency to the detriment of the competitiveness of other countries’ exports. It became a periodic ritual that US Treasury secretaries would visit Beijing to complain about the renminbi’s undervaluation.

Yet, in May, the International Monetary Fund (IMF) declared that China’s currency is no longer undervalued. In recent years, Beijing has modestly liberalized the exchange rate and loosened capital controls, which has brought a sizable increase in the value of the renminbi. Recently, there has been a surge in outbound capital flows, actually putting downward pressure on the renminbi. In fact, so severe was that pressure that the central bank has been selling rather than purchasing foreign currency lest the renminbi decline too much. The IMF clearly believes that we have entered a new world—even if the US government does not yet see it that way. As IMF Deputy Managing Director David Lipton put it: “While undervaluation of the renminbi was a major factor causing large imbalances in the past, our assessment is that the substantial real effective appreciation over the past year has brought the exchange rate to a level that is no longer undervalued.”7 The significance of the IMF view is that it will likely lead the organization to add the renminbi to the basket of currencies used to calculate special drawing rights (SDRs). While of no practical importance for China, having its currency as part of the SDR group has been a key goal of the government and represents China’s arrival as a major financial power.