A Minsky moment with Chinese characteristics?

With the Chinese stock market falling like a stone, half its stocks not trading and a sizeable portion of the remaining ones locked at the lower circuit levels, the question on every investor’s mind is: how badly will this affect the Chinese economy and, with it, the rest of the world? Could this be China’s Minsky moment—described by economist Hyman Minsky as a sudden collapse in asset values that have become bloated as a result of runaway credit growth?

On the 4th of July, the English edition of the People’s Daily had a brave opinion piece titled Government cannot be market’s babysitter’ But that noble sentiment hasn’t prevented the government from throwing all its resources into fighting the stockmarket fall, from banning initial public offers (IPOs) to telling brokers and insurers to boost stocks to providing loans to buy equities. If the problem were confined to the stock market, it wouldn’t really matter, simply because the market had gone up like a rocket and it was expected to fall equally abruptly. Nobody would have cared if it were just a few speculators getting burned. But why is the government so worried?

Simply put, the Chinese government is concerned about the social and economic implications of the market crash. Around 45 million individuals in China who have opened brokerage accounts since the beginning of April will lose their money because of the stock market crash, according to Credit Agricole estimates. With around 80% of the market turnover in China coming from retail investors, the Chinese government is worried about people’s wealth and incomes getting eroded.

True, household equity investments only account for 6% of the total financial investments, according to Societe Generale, but the wealth erosion is worrying at a time when the growth engine is slowing. Consumption growth is at risk as people lose their wealth in the market fall and become more careful about spending.

Dariusz Kowalczyk, senior economist and strategist at Credit Agricole Corporate and Investment Bank, says there is also a downside risk to investments which are financed through the financial markets—such as equity and bond issuances.

The capital market cannot provide sufficient funds any longer as IPOs were stopped and liquidity has been tightened, and it will become difficult to issue bonds and take out new loans. That will affect the corporate sector.

So far, the authorities have been unable to stem the fall. Raymond Yeung, senior economist, Greater China, at ANZ, says Chinese regulators failed to stem the market fall because they need more funds to offset the pace of de-leveraging as margin calls get triggered.

“Over the past several weeks, some highly-leveraged off-exchange margin positions in small and mid-cap stocks were force-liquidated,” said Nomura Research in a report dated 7 July. As a result, banks have lost money because they extended loans for stock investments. Since the stocks have fallen and investors are not able to repay loans, banks will be less willing to extend new loans to businesses. This will limit the potential for capital spending in the coming months,” said Kowalczyk.

In short, there’s likely to be an impact on China’s gross domestic product (GDP) growth if the rout is not arrested.

Economists are already estimating June-quarter GDP at 6.8%. The impact on the September quarter GDP growth will be around a quarter- to half-a-percentage point because of the impact on consumption and investment, reckons Kowalczyk.

The problem is that faith in President Xi Jinping’s abilities has eroded. Chinese investors realize that the mighty Chinese Communist Party is finding it difficult to stop the market rout.

At the very least, even if the fall in the Chinese markets is contained, it should alert investors to the higher risks in them. Moreover, the crash comes at a time when the country is re-orienting itself from an investment-oriented economy to a consumption-oriented one. Reports say that auto sales are sliding slowly but surely, as is demand for commodities such as metals, cotton and yarn.

The Chinese stock market crash will have some impact on economies which are exposed through trade, such as Korea, Japan and Australia, as a quarter of their exports go to China, according to Credit Agricole.

Commodity exporters will suffer. A commodity currency like the Australian dollar is down to new six-year lows.

Nevertheless, the risk of an emerging market sell-off is less because China’s markets are highly localized.

“The risk for emerging markets like India is from global risk-off trade because of the crash in Chinese equities, uncertainty in Europe and growing fears that the US Fed will start raising rates later this year,” said Vivek Misra, strategist-Asian equities, global research and strategy, Societe Generale. Indeed, low commodity and fuel prices are good for the Indian economy. India’s benchmark Sensex was down only 1.7% on Wednesday, outperforming the other Asian markets which plunged over 3%.

According to Yiran Zhong, Asia ex-Japan equity strategist at Nomura, “We do still see a strong Indian medium-term (and beyond) equity case, bolstered by prospects for a robust GDP growth resurgence as private sector investment revives, and with a structural decline in inflation amid an improved monetary policy regime. And for the near-term, better-than-expected monsoons so far have reduced risks to agricultural output and food inflation.”