4 reasons to worry more about China than Greece

By Jake Wallis Simons

The world’s second largest economy has a cold.

In Strasbourg and Brussels, Greece dominates the agenda. Half a world away, a more sinister economic storm may be brewing.
Chinese stock markets have been in free fall, down 30 percent in the last three weeks. The China Securities Regulatory Commission has warned of “panic sentiment” taking hold of investors. Major shareholders have been banned from selling for six months in a desperate attempt to shore up the market. Hundreds of companies have suspended their shares, freezing about $2.4 trillion worth of stock, or 45 percent of the market.

After unprecedented intervention by the Chinese government, China’s stock market bounced back Thursday with a 6.4 percent rise after five consecutive days of losses. The week ended with Shanghai’s Composite Index up 4.5 percent and the Shenzhen Component Index up 4.6 percent. But the potential for serious Chinese instability remains.
If you thought you should be anxious about Greece, save your fears for China. Here are four reasons why:

Risk of worldwide contagion

The Greek crisis has seen markets reacting with more stability than many anticipated. There are, of course, real concerns about the stability of the eurozone and future of the European Union, not to mention the pain in Greece itself. But the damage seems to have been contained for now.
By contrast, China’s troubles are already being felt around the world. Global stock indexes fell Wednesday night, with Chinese turmoil causing the yen — often seen as a port in a storm — to jump against the dollar.
The MSCI Asia-Pacific index has been hovering near a 17-month low, and the Australian dollar hit a six-year low against the greenback. There were also signs of damage in Japan’s Nikkei and South Korea’s Kospi.
Even the American market has been showing signs of being affected, with U.S. shares sliding sharply mid-week as a result of anxiety over China.
Beijing managed to quell the tide Thursday, when it banned major shareholders from selling and stabilized the market. This allowed some recovery to take place in Asian stock markets, and the European mining and metals stocks rose by 0.9 percent. U.S. crude, which lost almost 9 percent over the week, also responded to the measures, closing on Friday down 0.08 percent.
But analysts fear that this is only a dead cat bounce. And if the crisis continues, far greater instability could follow. Non-Chinese banks have lent more than $1 trillion to Chinese interests, and foreign hedge funds have billions of dollars of investment in China. This was highly profitable when the stock market was soaring, but now it exposes them, and by extension their economies, to significant risk.
Greece has roughly the GDP of metropolitan Miami, as economist Paul Krugman remarked on ABC last week. China, by contrast, is the world’s second-largest economy, accounting for “a third of global GDP growth,” said David Lubin, an emerging markets analyst at Citibank.
“The risk of contagion from China is very high, through trades, financial system interlink and impact on global investors’ risk appetite,” he said.
Add to this the fact that in the past three weeks, the Chinese stock market has lost $3.4 trillion in equity value — roughly 10 times the size of Greece’s annual GDP — and it’s enough to send a chill through the most seasoned investor.

A debt bubble

China is unusual in that most investors are private individuals rather than professional money managers. A study by China’s Southwestern University of Finance and Economics found that two thirds had not even graduated high school. In addition to exacerbating volatility, this has fueled a massive rise in “margin lending,” which means that brokers lend investors money to purchase securities.
This is all very well when the sun is shining. But when bad weather hits and panic sets in, brokers issue “margin calls,” meaning that they demand money from investors to shore up potential losses. This can trigger a domino effect as investors sell other assets to raise the necessary funds. Already there have been signs of this spreading in recent days, with copper flirting with a six-year low.
“Leverage in the Chinese economy, and lately in the stock market, is a key concern,”said David Cui, head of China equity strategy at Bank of America Merrill Lynch. “Credit has ballooned in the wake of the 2008 global finance crisis. Coupled with slowing growth, there is a possibility that a sizable portion of the debt may ultimately go bad.”

A political system unable to cope with crisis

The risks are high, and Chinese rulers seem to know it.
The country’s exponential growth in property and equity has relied fundamentally on debt. Now that things are — to use a British expression — going pear-shaped, the authorities are reacting in a highly interventionist manner, which raises questions about the depth of their commitment to market liberalization.
After a weekend meeting in which Li Keqiang, the Chinese premier, pledged to “counter the forces taking the market on its wild ride,” Beijing launched a series of emergency measures. These include demanding that private brokers pour money into the market by buying billions of dollars of stocks (using funds from a state-backed margin finance company), cutting interest rates and freeing up lending to banks, as well as introducing stock suspensions to combat “irrational selling.”
This bore fruit in the short term, with the MSCI broadest index of Asia-Pacific shares climbing by 1.8 percent Thursday and 1,300 Chinese stocks gaining the daily limit of 10 percent by the end of the week (though half of the market remains frozen). But aggressive intervention can have unintended consequences, and points to a system under immense strain.
A climate of panic remains among investors who are watching their life savings lose two thirds of their value. China Daily reported that after losing large sums on the stock market, fearful investors have been listing their homes at 10 percent below market average. And despite noises from within President Xi Jinping’s administration that there are “many policy tools we can use,” there is a growing worry that so many cards have already been played that there are not enough left in the deck.

The economy’s already slumping

China’s stock market convulsions are taking place against the backdrop of a slowing economy. The country’s imports and exports are both sliding, and in July GDP growth rate is expected to fall to the lowest it has been since 2008.
Between 1990 and 2010, the Chinese economy averaged 10 percent growth, driven by massive, credit-fueled investment. Last year, however, it grew 7.4 percent, and a slowdown is now taking hold.
Optimists argue that China’s real economy may not be affected by a stock market crash. But on Friday, the first evidence of this contagion emerged as China’s automakers’ association slashed its forecast for 2015 vehicle sales from seven to three percent. It has also been reported that Chinese real estate investors are taking their money out of the country and pooling it in safe haven markets in Canada, Australia and London.
With the crisis deriving from such deeply structural issues, the voice of optimism is growing less persuasive. And given China’s huge influence over the world’s economic health, even Greece cannot compete as a primary cause for concern.