Whats Going on in China?

July 10, 2015

A lot of things are going on in China, most recently a severe stock market sell-off, but rather than focus in on the last few volatile days, we felt it may be more helpful to take a step back and spend a little bit of time putting China into perspective. It’s important to remember that economic development on such a large scale level is a very complex matter and it’s nearly impossible for us to examine all of the variables, let alone be aware of all the moving pieces, but there are a handful of interesting observations that can be made regarding China and its growth over the last several decades. China is what is known in the financial markets as a developing or emerging economy, meaning that while it isn't completely developed like the U.S. or Western Europe, it is on the trajectory to become so at some point. In fact, China has developed so quickly and has had such a large impact on the global economy that, in a lot of ways, it is the poster child for the emerging market sector.   Being the poster child has given it a lot of hype which has in turn potentially created a bubble in its stock market, a concept that we’ll come back to shortly.

 

There are three basic ways that a country can experience economic growth: through growth in GDP (how much money it produces in good and services), through growth in the portion of its GDP it reinvests, and through growth in the price of its capital markets. Let’s tackle these one by one. GDP in the U.S. has historically grown at an average of 2-3%. China, however, has experienced a much higher GDP growth rate:

 

GDP growth (annual %)

 2010 2011 2012 2013 2014

 

China

10. 69. 57. 87. 77. 4

 

United States

2. 51. 62. 32. 22. 4

 

*retrieved from: http://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG

 

As you can see from the table, while China has grown at a much higher rate than the U.S., that rate is decreasing each year. This makes sense if you believe that China is nearing a state of being a developed economy at which point one would expect its GDP growth to level off at a rate similar to the U.S. and other developed economies.

 

The next source of growth can be a little hard to wrap your head around. We are basically tracking what portion of GDP is being reinvested into the country’s economic growth. You can think of it as being similar to the portion of a company’s earning that they choose to reinvest in research and development to keep the company growing. This number is a lot harder to track, but it is possible that the percent of China’s growth that it’s choosing to reinvest into more growth has peaked. A unique insight into this possibility comes from KKR, a multinational private equity firm, who noted on a recent trip to China that it seems China has started to shift its focus towards environmental concerns and away from job creation.

 

Because China is still a developing country, its regulations and infrastructure are not quite as advanced as the developing world, which has led to a serious issue with pollution in many of the larger cities there. It makes sense that China would start shifting its attention, and its money, towards some of those issues, but it also means that it may detract from investing in job creation and business development.

 

So far we have seen slowing growth in terms of China’s GDP, and a shift away from business development – two indicators for lower growth in China overall. In contrast, China has experienced an incredible surge in its stock market lately. The Shanghai Composite (a composite of the Shanghai Stock Exchange) rose 130% between September of 2014 and June of this year. Similarly, ChiNext (another exchange index) reached a price-to-earnings multiple of 150 in early June. In order to understand the volatility, it is important to understand several of the unique characteristics of the Chinese stock market. The first is that retail investors make up a large portion of China’s stock market activity such that they account for as much as 90% of daily turnover, meaning the majority of trading being conducted in China is not being done by institutions, but by average Joes. Secondly, as the market has continued to rise, those individuals have taken on a lot of margin and made some very risky bets. Not surprisingly, this scenario is looking more and more like the dot.com bubble of the late 90s.

 

So what are the takeaways? The first takeaway has been and continues to be that global markets are complicated, sometimes irrational entities that move quickly and China is no exception. Secondly, while China has exhibited phenomenal economic growth in the past, that growth is slowing as China seeks to become a more developed economy and world power by focusing on reinvesting in infrastructure and environmental health as opposed to boosting business growth and job creation. Finally, the volatility in China’s market should be viewed in light of the many singular individuals who are investing in it and the extent to which many of its stocks have become expensive and are in need of a correction.

 

The Economist (Jul 8, 2015). Uncle Xi’s Bear Market. The Economist. Retrieved from: http://www.economist.com/news/finance-economics/21657345-china-learns-stocks-are-beyond-communist-partys-control-uncle-xis-bear-market?fsrc=permar|image3.

 

The Economist (Jul 8, 2015). The Great Leap Backward. The Economist. Retrieved from: http://www.economist.com/blogs/buttonwood/2015/07/chinas-stockmarket.

The World Bank (2015). GDP growth (annual%). Retrieved from: http://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG.

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