China Economy – The Behemoth in the Room

It’s no secret that China’s economy has faced some pretty rough times in the last year. The world is still feeling the aftermath following “Black Monday” on the 24th of August. But are we out of the woods yet? Or are the global financial markets wrestling a bull twice their size? We’re going to look at China’s stock market and economy and make some predictions for the future.China High Building

The Chinese Stock Market

China’s stock market saw significant gains earlier this year. In June, China’s Shanghai Composite Index, which indicates the market’s performance, was up 60% since the start of the year – a six year high. People were investing huge amounts into the financial markets – after all, they were rising and no-one wanted to miss out. Fuelled by low interest rates (meaning people could easily borrow to invest) and laws that made it easier to buy and sell shares to the public, this pushed the market into a bubble. Shares were trading far above their intrinsic value, showing sure signs that a crash was to come.

What Goes Up, Must Come Down.

And down it did – on August 24th, the Chinese markets fell almost 8.5% in a single day, their steepest fall ever. Hundreds of billions of dollars were wiped from global share markets, leaving investors scared of what would happen to the world’s second largest economy and the worldwide impact that this would have. Chinese stocks have since rebounded, surging to 20% above its August low.

China OutlookOutside of the markets, Chinese growth is slowing, falling to around 7% per year. China is heading towards the end of its “industrial revolution” period, meaning that it won’t be seeing the same prosperity it achieved in recent decades. In fact, China is tackling its biggest slowdown in 25 years. This has a huge kickback on the rest of the world – global demand for commodity prices is falling. Iron ore exports from Australia are being hit as hard as oil exports from the Middle East. China’s slowdown, given its size, effectively means global slowdown. This was always inevitable – after all, such high growth is never infinitely sustainable, but that doesn’t mean that it’s not a shock to the globe.
See the problem here? The stock market is ramping up, while the companies that the stocks represent are slowing down. Currently, Chinese stocks are trading at a price to earnings ratio of around 38% above their five year average. A representative from Credit Suisse (a highly regarded financial services juggernaut) has gone on record to say that this is essentially another bubble – and he could well be right. The fundamental value (the earnings and the assets) of these stocks haven’t improved, but their prices have soared. When prices get too inflated, the market will correct itself again, like it did in August. But at what cost to investors and the rest of the world? Who knows.

Government Stimulus

In order to bolster growth, the Chinese government has decreased interest rates six times in the last year (it currently sits at 4.35%). Lower interest rates are the government’s way of trying to encourage spending and economic growth – so that it becomes cheaper for people to borrow money and invest it into their business or personal projects. However this is a double edged sword – making it easier for people to borrow money to invest in the stock market. When people have more money, the demand and therefore the price of these stocks increase substantially, throwing fuel on the stock market fire.

Does this mean that the world will collapse? After all, China is a huge player in the global markets.
Well not quite – the world has survived worse, such as the 2008 Global Financial Crisis. But a market correction seems quite likely if share earnings (and therefore underlying value) continue to underperform compared to the market price. Though, the world is bracing itself for this, so the impact will be lessened as people diversify and hedge their bets away from the volatile mass that are China’s financial markets. For example, the Fed’s decision to hold interest rates was justified by “uncertainty abroad”, likely referring to China’s instability. It seems global markets are therefore preparing themselves to withstand another crash.

Regulation issues

A number of Chinese stock market regulative professionals have been fired for, what appears to be, corruption. Many argue that China’s stock market regulators have been incompetent for years now – following a policy of “do nothing until something goes drastically wrong”. While some of these have now moved on, it shows a very worrying lack of preparation and understanding as to how to deal with global fallout. This attitude has also been prevalent in other areas of Chinese regulation – pollution, food safety and working conditions. In China’s move to becoming a modern economy, it must address these issues. In the meantime, a stock correction is inevitable. Exactly when this will occur is, quite literally, a trillion dollar question.

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