Stock markets: A simple correction or the beginning of a meltdown?
IMD Professor Reacts: Arturo Bris on China-led market declines
August 25, 2015
Financial markets tend to be boring during the summer. A decrease in market activity, coupled very often with a lack of macroeconomic events results in low volatility and few surprises. Over the last 30 years, the average performance of the FTSE100 index during the months of June, July and August has been 1.08%, while the Dow Jones has remained virtually flat.
The exceptions to this rule have been of course 2008 and 2015. This year alone, the FTSE is down 15% compared to three months ago, the Dow is down 12%, the Euro Stoxx is down 15% and the Nikkei has dropped 8.3%.
However, domestic problems aren't causing tumult in these regions—it's all originating in China. As of August 24, the Shanghai Composite Index has dropped 32% over the last three months, and an impressive 40% from its peak on June 12th. (As I write, the index has fallen an additional 7.63%).
Those who believe that what we are witnessing is a market correction with prices getting closer to their fundamental values refer to a similar situation in 1998. In that year, news from Asia triggered price declines all over the world, only to see similar price levels return one month later. Therefore—it is argued—we will see something similar in China once investors realize that the prices they were paying did not correspond with the true potential of both the corporate sector and the overall economy in China.
I am less optimistic and have long argued that China is now a major risk factor for the world economy. The current market crashes are perhaps the beginning of a long period of transition towards China becoming a "normal" country. I am using the term that Andrei Shleifer (Harvard) and Daniel Treisman (UCLA) used in 2005 referring to Russia at the turn of the century. After communism and the 1998 crisis, Russia became a normal middle-income country, similar to Portugal and Mexico.
From rising star to new "normal"
Today, China is the second largest economy in the world, but it is #22 out of 61 economies in the 2015 IMD World Competitiveness Rankings (Russia is #45 by the way). It is therefore a "normal" country, even if it is a huge normal country. And the Chinese economy will still take a long time to address its fundamental challenges: an inefficient government sector, which is opaque and with high levels of corruption; a corporate sector lacking adequate regulation and over-protected by the public sector; and very poor infrastructure, education and health systems that restrict quality of life. Markets are finally telling us that the party is over.
China as a risk to the world economy is the result of a combination of factors. First of all, China is a very large economy—much larger than Russia in 1998 and Greece in 2015. It is the largest foreign investor in the US and also a significant holder of US government debt. China is the largest exporter in the world and close to becoming the largest importer. Finally, four of the five largest banks by assets in the world are Chinese, and their combined balance sheets amount to $11 trillion. That is about 100% of the country's GDP.
Time to worry?
We should not disregard a 40% market drop in China as a mere correction. In terms of market capitalization it represents a wealth loss of $2 trillion for Chinese firms and international investors. This is equivalent to Brazil's GDP. I think these are reasons to be extremely concerned. But if they are not enough, let me add two final points:
We can't ignore the important capital structure effect of the Chinese sell-off on the corporate sector. The McKinsey Institute reported in February 2015 that the ratio of corporate debt to GDP in China is a staggering 125%. I am much more worried about that than about Greek government debt being 175% of GDP. Therefore, in addition to the direct wealth effect of the crisis and the negative sentiment that it creates, we have to be concerned about the likelihood of corporate defaults, and subsequently bank failures, in China in the coming months.
Markets are an amazing human creation, but we either believe in them or we don't. China has shown the world that the market mechanism explodes if you try to control it too much. During the past months we have witnessed the attempts of Chinese regulators to prevent a market crash, to no avail. First it was the prohibition on short-selling. Then the prohibition to sell that applied to institutional investors. Recently there was also the change in regulation allowing pension funds to invest larger amounts in equity markets.
Financial markets need to be regulated to make sure information is truthful and transparent. But when the regulator tries to manipulate markets, the consequences can be dramatic. We are seeing this play out now in China and the rest of the world.
Arturo Bris is Professor of Finance at IMD and directs the IMD World Competitiveness Center. He will be giving a keynote speech at IMD's Orchestrating Winning Performance (OWP) which takes place from 16-20 November 2015 in Singapore.