So how screwed is China? And how screwed are we?
According to Patrick Chovanec, a longtime China watcher who is currently chief strategist at Silvercrest Asset Management, the news for China is grim — at least for a while. But the news for America is, well, pretty cheery. China's problems are part of a rebalancing that's long overdue — and could well redound to America's benefit.
I spoke with Chovanec, who was formerly an associate professor at Tsinghua University’s School of Economics and Management in Beijing, by phone on Wednesday. Here's what he told me.
The stock market crash is a symptom, not the cause, of China's problems
The big point Chovanec made is that China's stock market crash isn't the problem — it's a reflection of the problem.
"China is undergoing a profound economic adjustment from one kind of growth model to another," he says. "It has outgrown the export-led growth model that led it to rely on external demand and high internal investment. So now it needs to shift to a model that is more balanced between investment and consumption.
"But instead of doing that, for the last five or six years, China's government doubled down on investment. It had a lending boom, an investment boom, it pumped huge amounts of money into building factories and ports and infrastructure. So there’s a lot of overcapacity and bad debt. That bad debt has become a drag on the economy."
The stock market boom was built on government boosterism, inexperienced investors, and so, so much debt
The story of China's stock market boom, Chovanec says, is the story of the Chinese government pushing people into a debt-fueled binge.
"The Chinese property market went down, so people who were putting their money in property began looking elsewhere for returns," he says. "And when they looked around, the government began talking up the stock market. It opened up the door to margin lending, and margin lending exploded."
Let's stop for a minute here and define "margin lending": In the simplest form, margin lending just means borrowing money to buy stocks. It's great if the stocks rise in value. It's a disaster if they fall in value.
Until recently, these transactions — which are common in stock markets all over the world — were prohibited in China. But then the Chinese government lifted the prohibition. And margin lending absolutely exploded.
"Margin lending was inconsequential two years ago," Chovanec says, "but it has risen many times over since then."
This point can't be overstated. The amount of margin lending in the Chinese stock market went from basically nothing to an all-time record for any stock market in history within a few years:
Something to note here: The investors doing all this margin lending were not sophisticated veterans of global finance. As Ruchir Sharma wrote in the Wall Street Journal, "At the leading brokerages, 80% of margin finance has been going to retail investors, many of them new and inexperienced" and "two thirds of new investors lack a high school diploma."
Problems are evident elsewhere in China's economy, too
"The stock market is kind of a sideshow to much more significant problems with the Chinese economy," says Chovanec. "The thing about the stock market is it’s easy to see. When prices go down, you see them go down. But in property and steel and iron ore and shipbuilding and local government debt, you can brush a lot of stuff under the rug and you don’t know what’s going on.
"I think China's been having a hard landing over the last two or three years. It used to be that a hard landing was anything under 7 percent growth. But in the first quarter of this year, according to official statistics, it was closer to 5 percent growth. And a lot of people think the official statistics are too high."
Long term, China's adjustment might be good for the US economy
Perhaps the most surprising argument Chovanec makes is that China's problems are, long term, good news for the United States.
"The pattern of growth China was engaged in was not sustainable," he says. "I’ll give you a concrete idea what I mean by this. China’s boom was an investment boom. It bid up the prices of inputs. Anything that went into building this stuff, like iron ore or copper or oil, became more expensive.
"But the flip side is it was deflationary for people making these things. A vivid example was the solar sector. China built out a tremendous amount of not particularly innovative solar capacity. The price of solar production plunged, and it drove everyone else out of business, and then it eventually drove the Chinese solar producers out of business, too. There was just too much excess capacity being created."
America tends to make finished products that require a lot of skill to produce. China was driving up the price of the materials and, with its subsidies and currency manipulation, driving down the price of its finished products. Both trends were a disaster for American producers. And if that era of Chinese growth is finally calming, then that's probably good news for America.
The other piece of good news, Chovanec says, is that a stock market crash in China may not mean a big hit to Chinese demand.
"Normally crises happen in deficit countries. If earnings go down, they can’t afford to buy stuff. The Chinese have been producing more than they consume for years. They have $4 trillion in reserves. They can buy goods and services from abroad. That’s a cushion for them: If their output falls, they can maintain their living standards. And that’s really good for us because it increases net demand."
The takeaway, for Chovanec, is that "from the point of view of the global economy, what matters isn’t how much China is producing, but how much the Chinese consumer is consuming." Rebalancing won't be easy, and it may mean a couple of years in which China both produces less and consumes less. But ultimately, it also may mean that China does less subsidizing of production — which has been its strategy until now — and more to encourage consumption, as that's going to be necessary for its future. And a China that consumes more is a China that can buy more from America.
The catch: China could try to devalue its currency as a short-term fix
The optimistic scenario isn't the only possible scenario, Chovanec says. "The Chinese could say, 'We don’t want that rebalancing, so we’ll devalue our currency.' That would be really bad for the long-term shifts that need to happen in China, but it’s tempting for them; they're under a lot of pressure to do it. They’ve resisted it so far, but if they went with that, you would have a situation where they’re trying to shore up a model where the US is the consumer of last resort. That’s bad for the US, but it’s bad for China too. Eventually, the balance of payments has to balance."