China’s Stock Markets

The Issue Is Not China’s Stock Markets – It’s the Model

By Scott B. MacDonald

In late February 2007, the global stock market meltdown started in Shanghai. As The New York Times noted on March 4, 2007:

“Less than a week ago, it might have seemed preposterous to suggest that a 9% fall in the Shanghai stock exchange could jolt markets across the world, triggering declines in everything from European stocks to American corporate bonds.”

Yet there it was – a bad day in Shanghai shaking up global markets. Although the great revolutionary helmsman, Mao Zedong, had hoped China would shake the world, he would have been very surprised it was the Shanghai stock exchange, not the Red Guards.

While considerable attention is given to the rough-and-tumble nature of China’s stock markets, more concern should be devoted to the growing need for Asia’s largest country to change its economic model. Without changes, China increasingly runs the risk of a major crisis that will encompass a harsh economic downturn as well as socio-political upheaval. Such a turn of events would have repercussions everywhere, considering China’s importance in the global economy.

Putting China’s Success in Perspective

By any standard China has been remarkably successful – its long-term economic expansion pulled more than 200 million people out of poverty over the past 30 years. Per-capita income is approaching $2,000 a year, and the population is moving into the auto age. It is also a member of the World Trade Organization (WTO) and most Fortune 500 companies are actively engaged in the China market. Like it or not, it is difficult to ignore China, considering its substantial role as the world’s workshop. China boasts of low wages and high quality work conducted by a well-disciplined, educated and nonunion work force. This has proven to be a powerful combination and allowed China to carve out considerable market-share in businesses including textiles, car parts, and industrial machinery.

China’s economic model is oriented toward absorbing migrant rural labor into capital-intensive, export-geared manufacturing industries. Along these lines, there has been a steady shift of population from the countryside to the city. This creates a floating workforce of anywhere between 60 and 100 million people. It has made a reserve labor pool that keeps wages low, while maintaining a major competitive advantage for China in international markets. Chinese economic policymakers have built upon this cheap labor system with tax rebates, systematic under-pricing of energy resources, and the undervalued exchange rate. And the foreign investment has come – by one calculation, around $700 billion has entered China over the past two decades, setting up factories, creating distribution networks and training local work forces.

China’s success has not come without controversy. As China’s cheap labor export model gained momentum and captured market share starting in the 1980s, other countries lost out, ranging from the United States, Japan and the European Union to Mexico, Malaysia and Thailand. China currently has one of the largest trade surpluses with the United States and is identified by many American businesses and workers as a stealer of jobs, armed with unfair trade practices. In particular, complaints highlight the turning of a blind eye to massive copyright infringements worth billions of dollars in lost revenues for U.S. companies and an intentionally undervalued currency exchange rate.

The last has become a major point of contention between China and its major trade partners. As the U.S.-China Economic and Security Review Commission noted in 2005: “China’s undervalued currency encourages undervalued Chinese exports to the U.S. and discourages U.S. exports because U.S. exports are artificially overvalued. As a result, undervalued Chinese exports have been highly disruptive to the U.S. and to other countries as well, as evidenced by trade remedy statistics.” This has echoes in the Democratic-controlled Congress, where more protectionist legislation is being considered. As Democratic Congressmen Sander Levin, Chairman of the House Ways and Means Committee’s Trade Subcommittee stated in March 2007: “Our trading relationship with China is unbalanced and unsustainable.”

China’s rising economic power has also made its presence more evident in the far reaches of the planet. This includes a natural resource-driven foreign policy that is putting China in bed with unsavory regimes in Africa such as. Sudan and Zimbabwe, and industrial pollution that is seeping across national borders. Consequently, China’s success is also leading to problems in how it interacts with the rest of the world, especially as it is regarded less as a “developing “country and one of the rising economic powers.

Why Change Is Needed

Although external pressure is an important factor in why the Chinese economic model needs to change, domestic reasons are more significant. In particular, China’s model has resulted in profit and taxes growing faster than wages, which has concentrated economic power in the hands of companies and the government. The losers in this exchange have been the workers – wages have declined as a portion of GDP in recent years. According to the World Bank, the share of wages in the Chinese economy declined to 41% of GDP in 2005 from 53% in 1998. In comparison, wages account for 57 percent of GDP in the United States. In addition, while savings are high, consumer demand is constrained due to concerns about poor insurance and costly health care.

Failure to make changes increases the probability of a major economic and political meltdown over the next few years. For all of its success, China’s economic development remains fragile. Asia’s largest country is going to have problems with adequate water supplies, energy, the environment, and income disparities. In addition, the banking system remains opaque and has extended considerable credit to fuel the building boom leading up to the 2008 Olympics. All of these are underlying weaknesses, but if there is a major slowdown in growth, the workers are likely to be the ones who take the brunt of a downturn.

One possible flashpoint is in how China reigns in the current economic and investment boom. Real GDP in the 2004-2006 period has been over 10% and investment has flowed into construction, real estate markets and industrial inventory. Easy bank credit has also meant many first-time borrowers putting their money into the stock market. As one observer noted: “Mortgage applicants often conspire with real estate agents to secure home loans before shifting funds to a third party bank account.” That loan often goes into stocks. According to Yin Jianfeng, a researcher at the Chinese Academy of Social Sciences’ Institute of Finance & Banking, some 300 billion to 500 billion yuan of banks loans, almost all refinanced mortgages and revolving consumer loans, may have gone into the stock market in the past year. This works well when the stock market goes up and the Shanghai and Shenzen index was up substantially before February 27th. However, when the market moved lower and values plunge, panic ensues.

Chinese government measures have had only a limited success at cooling the boom. While February 27th was a signal that something is wrong – an overheated stock exchange and probable insider trading – a more fulsome unraveling of Chinese stock markets could spread into other parts of the economy. The issue of fast money and weak regulation continues to dog the economy, a potential Achilles Heel that only reinforces the need for changes in the economic model.

One aspect of China’s success has been its ability to deliver on strong economic growth. If nothing else that has meant the Chinese economy remains on the move and, with it, the belief some of the benefits in the system can be obtained by all. Take away the fast pace of growth, the myth of upward social mobility gets stripped from the social equation and the door opens for discontent on a large scale. Most Chinese are aware they live in a more affluent society, but differences between the growing upper and middle classes and the rest of the population, much of it still rural, represent a growing societal fault line. The ratio of urban to rural incomes is now 3- to-1, while there is a ten-fold divide between per- capita GDP in the wealthiest coastal province and the poorest landlocked region.

China’s approach to globalization is creating two countries. One is connected to the global grid, increasingly affluent and influential. The other country is less connected, poorer and lacking influence. But the second China is growing more aware of corruption, the weak rule of law, and the disparity of national wealth. These two worlds are moving into collision as the rural population wants and needs change, but the urban population is more driven by the desire for the status quo. Social unrest in the countryside is a growing concern. China’s globalization has brought tremendous benefits, but continued change does not necessarily offer more upside. Hence, China’s very success is pushing it into a new environment of conflicting socio-economic currents.

The Quest for a Harmonious Society

China’s leadership is aware of the scope and scale of the challenge. In October 2006, Premier Wen Jiabao outlined his vision for a “harmonious society”, which emphasized the need to deal with socio- economic disparities. In March 2007, Wen admitted the growth model needed refining to better protect the environment and those less well-off in society. At the same time, China’s national legislative body passed a corporate income tax (which ends special benefits for foreign firms) and finally (after 13 years of debates and amendments) a law providing protection to private property ownership. Both of the last- mentioned are radical steps forward as they move China more in line with other countries though the action vis-à-vis foreign firms could hurt foreign investment.

While China’s leadership recognizes the need to change the economic model, to slow the pace of growth and to better distribute national wealth, there remains pressure not to move too quickly, especially from interest groups, including members of the ruling Communist Party. Premier Wen stated in March, 2007: “For our socialism to go from being immature to mature, unperfected to perfected and undeveloped to developed, will take a very long time.” But China may not have that much time.

China needs to shift from such a heavy reliance on export-geared manufacturing to the development of higher-paying services for local consumption. This would certainly help stimulate consumption, help unwind industrial overcapacity, mitigate trade friction with the United States, Japan and the European Union, and slow the pace of potentially inflationary foreign exchange accumulation ($1 trillion). It would also ease over time the pressure for China to let its currency appreciate; such a measure could be taken in an incremental fashion as the service sector grows in strength.

Globalization and Its Potential Disconnects

Although there is a steady drum beat for China to move rapidly to let its currency float and to adopt protectionist trade acts such as the one currently under consideration in the U.S. Congress, the changes that count the most come from China. This is because they are important for the future of that country in its maintaining political order in a changing society and becoming a more reliable member of the community of nations.

Any major disruption of the Chinese economy could have a negative impact on the U.S. economy, considering that Chinese savings help fuel the U.S. consumer binge. The Chinese, along with other Asian central banks, have been some of the largest buyers of U.S. Treasuries and corporate debt. According to the rating agency Fitch, Chinese holdings of U.S. Treasury securities amounted to $350 billion at year-end 2006, in addition to an estimated $230 billion in U.S. agency bonds. This has been an important source of capital as the U.S. consumer has been running on either negative or close to negative savings rates for the last couple of years. In a sense, Chinese savings help U.S. consumers buy Chinese exports at sale at WalMart, Target and other retail discounters, while the low costs of production put many of the same people out of work. Consequently, China looms large in the U.S. economy, both as a low-priced source of consumer goods and capital as well as a competitive economic challenge.

Conclusion

If China does not make the changes needed in its model, the next time that Shanghai is hit by a stock market meltdown, the danger could well be that the ripples will go deep into the country’s political economy. Such a development would certainly hold out the threat of what China’s leadership fears the most – societal upheaval that ousts the old regime and ushers in another one of the Middle Kingdom’s periodic bouts of chaos and warring kingdoms. And that would be in no one’s interest.

While the information and opinions contained within have been compiled from sources believed to be reliable, KWR does not represent that it is accurate or complete and it should be relied on as such. Accordingly, nothing in this article shall be construed as offering a guarantee of the accuracy or completeness of the information contained herein, or as an offer or solicitation with respect to the purchase or sale of any security. All opinions and estimates are subject to change without notice. KWR staff, consultants, authors and contributors to the KWR International Advisor, Special Reports, Market Viewpoints, Guest Opinions, Alerts and all other articles may at any time have a long or short position in any security or option mentioned.