Derek Holt and Frances Donald are vice-president of economics and financial markets economist, respectively, at Bank of Nova Scotia.
Calling a direction or level in China's wildly gyrating and policy-distorted stock markets is challenging, to say the least. What matters more to the world is the potential macroeconomic impact of China's equity market correction.
The impact is likely to be modest and short-lived while evading hard-landing concerns for the broader economy yet again. If the effects turn out to be worse, then the state holds enormous ability to manage and counter the consequences. Simultaneous consideration must be given to the possibility that China's property market is beginning to bottom and show nascent signs of responding to stimulus efforts. This could be a more powerful support to China's economy over time.
Even at its mid-June peak, China's stock market rally was smaller than the 2007 bubble, during which the market capitalization of mainland Chinese equities soared to over 160 per cent of GDP before collapsing to about 50 per cent into the global financial crisis. This time, market cap peaked at 80 per cent of GDP and is now running at 60 per cent – roughly half that of more stock-market-dependent economies like the United States, Britain and Canada.
This is not to belie the fact that the price-earnings (p/e) ratios are very high for many of the companies listed on the Shanghai and Shenzhen exchanges. These ratios have fallen dramatically since June and remain rich, but aside from the large state-owned enterprises with cheap multiples, they should be compared to other global small-cap exchanges. The value of the total stock market to the size of the economy is superior to considering p/e ratios as a first step toward evaluating the macroeconomic effects of the correction. And note, of course, that the value of China's stock market is still almost $3-trillion (U.S.) higher than it was at the start of the rally last summer, when it was among the most undervalued markets anywhere.
The largest direct negative effect of a pronounced stock market decline will be a slowdown in initial public offerings. This was already likely before the government imposed an IPO ban. However, equity issuance remains only a small part of financing in China, worth about 5 per cent of aggregate financing, and we doubt that corporate finance will be meaningfully derailed.
Existing research has found China's stock market wealth effect on consumer spending to be low to non-existent, and possibly even negative, as stock-market gains can crowd out other forms of returns and cash can be diverted to equity purchases in lieu of consumption. In part, this is because there is still only a very small proportion of Chinese households directly invested in the equity market. The China Securities Depository and Clearing Corporation lists 90 million investors in mid-June, which works out to about 8 per cent of Chinese adults. Moreover, only 55 per cent of those investor accounts actually contained any securities, suggesting that active investor participation is even lower.
Chinese retail sales growth has trended lower throughout the past year's equity rally and is at its weakest rate in a decade, which offers little evidence that rapid paper gains in equity markets were being spent. Also note that even had this not been the case, consumer spending as a share of GDP in China remains about half that of the U.S. economy.
Financial intermediation remains a small share of the economy, at about a six-percentage-point weight in Chinese GDP, and we find little evidence of meaningful linkages between GDP in the financial intermediation sector and volume measures of stock market activity. At the very most, a slowdown in activity in the brokerage and related sectors will temporarily knock about a quarter-point off Chinese GDP growth.
While elevated levels of leverage are a risk to further equity-market volatility and losses, recent regulatory changes coupled with clear policy support from Beijing suggest to us that a series of margin calls do not yet pose systemic risk. Outstanding margin loans have now fallen by 36 per cent to a four-month low from their peak value in June, but are still 80 per cent larger than they were in November, 2014, when growth really accelerated. A key point is that margin loans are very heavily over-collateralized on average. Stocks and cash held as collateral equalled 277 per cent at the peak in May. We recognize that the "average" may not be representative in this case and that the most recent entrants may be the most vulnerable to leveraged equity purchases. The broad margin loan market poses limited macro risk of margin calls with loans to capitalization at a similarly low proportion to Western markets and with little exposure within the banking system.
We are not unconcerned about the macroeconomic effects of correcting Chinese equity markets, but not sufficiently worried to view it as hard-landing material, versus a relatively minor and short-lived drag on economic growth and financial stability. With $3.75-trillion in accumulated savings through foreign reserves and little external debt, the country has enormous flexibility to paper over domestic imbalances in debt and asset markets, as it has done in the past. As macroeconomists, we don't position a country with enormous external finance strengths at the top of the list of countries facing an impending balance of payments crisis or downward economic spiral.
To be sure, China's interference with price discovery in equity markets through various policy responses to the equity market correction is risky and carries uncertain long-run consequences. It hampers trust in the market and will raise liquidity risk premiums. This is similar to elsewhere in world markets. In our view, the important point is that macro risks posed by China's correcting stock market to both China's economy and the world economy are reasonably limited and manageable.