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China's Stock Crash: Will a Depression Follow?

Jul 15, 2015
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SMITH BRAIN TRUST -- The Chinese stock market meltdown bears more than a passing resemblance to the U.S. crash of 1929. Many observers have noted the similar scale of the two implosions: The Dow fell by 25 percent in the week of Black Thursday; from June 18 to July 3, the two main Chinese markets fell by 31 percent. But the parallels go beyond scale, according to Albert "Pete" Kyle, a finance professor at the University of Maryland's Robert H. Smith School of Business.

From a structural perspective, he says China is at roughly the stage of economic development as the United States was 80-odd years ago. For instance, in China today there is little social safety net, the income tax is a relatively new intervention, and an emerging middle class is looking for places to invest in order ensure a decent retirement. Yet these new investors also lack financial sophistication—not unlike those in the U.S in the '20s. (That China resembles the U.S. of the '20s does not mean it will take nine decades to catch up because China's growth rate is faster.)

An older generation of Chinese would buy a farm to make their retirement secure, but as the country urbanizes, that approach often no longer makes sense. As a result, "All these people in the top 10, 20 or 30 percent of the country, in terms of income, are investing in things they don't understand," Kyle says. "The first thing they invest in is a house—but then they turn to stocks and bonds." (China's real estate markets have also tumbled.)

By one estimate, 9 percent of the market capitalization in the Chinese markets was generated by stocks bought through loans. A similar pattern held in the United States: From 1926 to 1929, both the level of the margin debt and the level of the Dow Jones average doubled in value. Moreover, in both places the boom in prices was focused on emerging growth companies, Kyle says.

As China seeks to prop up its stocks, it's getting criticized for meddling in markets, but American policy was not so different in the 1920s, says Kyle. "When the decline occurred, the U.S. did a lot that resembled what China did," he says, "but it wasn't a concerted federal policy. It was more spontaneous." China has essentially ordered its major brokerages to create a $19 billion fund to invest in the market and drive it back up, hardly a laissez-faire approach. But in 1929, J.P. Morgan and other bankers orchestrated a fund of $750 million (more than $10 billion in today's money) to buy equities. 

Moreover, both nations made concessions in order not to force people to sell stocks to pay off their margin loans, China by government fiat, U.S. banks by private policy.

The Chinese interventions strike Kyle as reasonable, but more important may be what happens next. Where the United States and other nations went astray in 1929 and afterwards has less to do with how banks responded to the crash than with monetary policies, he thinks. Specifically, national banks strongly resisted devaluing currencies. Devaluing the national currency makes it easier to sell exported goods and also makes imports more expensive, stimulating demand for domestic goods.

"I think there's no way that China's going to make that mistake," Kyle says. "China manages its currency — or is alleged to manage its currency — to keep it cheap. So I don't think the stock market decline in China will lead to a depression in China."

There are other differences. The rise in China's markets was so rapid that the subsequent crash wiped out less than a year's worth of gains. So while many people are feeling poorer — and are poorer, on paper — many also have more savings than they did a year ago. So consumption is likely to decline less than it would if the crash had erased gains that accrued over a longer period. "That 'wealth effect' [from the stock market boom] never really had a chance to manifest itself as a spending boom because it happened so quickly and disappeared so quickly," Kyle says.

Secondly, China restricts capital outflows, so citizens who might have otherwise looked to invest abroad, given the situation at home, will probably find they have no choice but to invest domestically. "So I think the stock market and the property market will stabilize," Kyle says.

Still, China's stock-market collapse is already having broader ripple effects than that other economic calamity in the headlines: Greece. Greece is only minimally intertwined with the global economy. In contrast, large-scale commodity exporters, including Australia and Canada, have already taken a hit, and they will continue to be hurt if China's demand for material to fuel its once-robust economy stays flat, Kyle says.

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