China´s stockmarket bubble

21.05.07 Publication:

What is a bubble? No one really knows: people tend to agree on what bubbles are only after they have burst. But a pretty fair indicator is when a stockmarket index has risen by more than 150% last year, and has risen by more than 50% so far this year. The market in question is the one in Shanghai. And if the financial authorities in China are not worried that the Shanghai bubble might soon burst, then they should be.

            In fact, they clearly are worried. The Chinese central bank has warned retail investors about the risk that share prices might collapse. But there is little that the central bank can do about it, apart from issuing warnings. For the bubble is one of the consequences of an economic policy adopted by China for other reasons entirely: the use of a semi-fixed and undervalued exchange rate to keep exports cheap, which in turn means that monetary policy has to be kept very lax. Sooner or later, the bubble will burst or else that policy will have to be changed.

            When? We cannot know. But the stockmarket bubble is a clear indicator that a crisis of some sort is on its way for China. To use that word “crisis” does not mean that the result will inevitably be a disaster. It means, instead, that there will have to be a substantial change in China´s economic policy and in the economy itself.

            Any mention of bubbles naturally brings to mind Japan´s bubble of the late 1980s, and so also naturally brings up the question of whether China is about to suffer from the same consequences as Japan did during the 1990s. That parallel between Japan in the past and China today may not, however, be the most illuminating one. A better parallel may be the history of Japan as it entered the 1970s and then confronted the first oil shock.

            During the 1960s in Japan, private firms´ investment soared, encouraged by the yen´s cheap and fixed rate, and by easy credit. Investment reached nearly 40% of GDP in 1970-71. But then two things suddenly forced a big change in economic policy: America abandoned fixed exchange rates, producing an upvaluation of the yen; and the hike in oil prices by oil producers in 1973 raised Japanese industry´s costs and created inflation. The result was a restructuring of industry to deal with expensive oil and the dearer yen, and an expansion of Japan´s budget deficit, to support economic growth.

            China is at a similar juncture. Investment has risen to even higher levels than in Japan, passing 43% of GDP. Again, private investment has been encouraged by easily available credit and other capital, and by the cheapness of the Chinese yuan, which helps exports. To maintain such a cheap yuan, the Chinese central bank has had to buy huge amounts of foreign currency, lifting foreign-exchange reserves to more than $1.2 trillion, an unprecedented level. Booming exports and slow-growing imports have lifted the current-account surplus to nearly 10% of GDP, which is also unprecedented for such a large economy.

            Something has to change. And, again, the government is well aware that it must. Chinese leaders, especially Premier Wen Jiabao, have been making speeches for more than a year saying that the economy´s growth path is unbalanced and unsustainable, and that public spending should be increased in order to transfer resources to health care, education and other public services. But little has actually happened. Meanwhile, investment keeps on growing.

            Little has happened because local governments, and powerful forces in the Communist Party, want to keep investment booming, for they profit from it, and want to protect their backers in export industries. They cannot see why anything should change. In a sense they are right: there is no reason in principle why investment cannot keep on rising, to even higher proportions of GDP. The problem, though, is that the fuel for the investment boom—cheap money and a cheap yuan—are bringing inflation.

            The money supply is growing rapidly. Increasingly, that growth is being reinforced by the rapid growth in foreign-exchange reserves. Central banks try to “sterilise” that growth to prevent it feeding through into inflation, but in China´s case the growth has now become too fast to be entirely sterilised. As in Japan during the 1980s, consumer price inflation looks low but inflation is showing up in share and property markets.

            As Premier Wen Jiabao has said, the current trend is unsustainable. The question is how it will change. The change could be provoked by a collapse in share prices. It could be provoked by an external shock such as an American recession combined with a rise in protectionism. Or it could occur as a result of a political agreement, during or after the Communist Party´s 17th party congress this coming autumn, to control inflation and investment by making a sharp upvaluation of the yuan, probably followed by a substantial increase in public spending on health, education and social services.

            The best option for China would be the third of those: a deliberate policy change, achieved through political agreement. Just as likely, though, is some combination of all three options, which would be more disorderly. Just as Japan in the 1970s and 1980s continued to be a successful economy, with a falling investment rate that was still higher than was typical of other economies, so China could come through this crisis with plenty of growth potential ahead of it. But it will not be an easy or smooth process. And as it happens, other countries will be affected too—not least Japan.