SMITH BRAIN TRUST -- The Center for Financial Policy at the University of Maryland's Robert H. Smith School of Business hosted a forum on Global Market Volatility on Sept. 8, 2015, aimed at making sense of the recent tumult in international markets — notably in China, but also spilling over into other regions, including the United States. Below are some observations by participants in the forum, which was moderated by Russ Wermers, director of the Center for Financial Policy. Participants' remarks have been lightly edited, for clarity.
Where China was concerned, Haluk Unal, a professor of finance and special advisor to the Center for Financial Research of the FDIC, said that much blame could be attributed to the heavy borrowing that has financed the Chinese economic boom, as well as high fixed operating costs:
"Since 2007, China's total debt quadrupled, rising from $7.4 trillion to $28.2 trillion. In other words, it was 158 percent of GDP and grew to 282 percent of GDP. This is much higher than the U.S., Australia, Germany and Canada. So China is really hugely leveraged. Half of the loans are linked directly or indirectly to real estate markets, and there's an unregulated shadow banking system that accounts for nearly half of the lending ... China's rising debt accounts for about one-third of the rising increase in global debt since 2007. So China is borrowing like crazy in order to sustain its investment growth."
"Investment growth means huge fixed operating costs, which implies a huge level of operating leverage [ncluding depreciation and maintenance costs]. And the exports — if you look at 2003 to 2007 level, they were increasing at a rate of 26.7 percent. Between 2010 and 2014 it fell down to 7 percent. So there's huge financial leverage, huge operating leverage, and the decline in exports caused earnings to come down much faster than the decline in sales. It's therefore not surprising that between June 10 and August 26 the Chinese stock market declined 42.67 percent. That's about $5 trillion in stock market loss in about 2 months."
Asked by Wermers what had caused exports to slow, Unal pointed to trading partners who were not nearly keeping pace with China's recent growth rate of some 9 percent per year. With the U.S. growing at around 1.2 percent a year, the Eurozone flat, and with Australia at about 2.4 percent, a slowdown in Chinese export growth was more or less inevitable, Unal said. China is already heavily investing in infrastructure, so the government's stimulus tools are limited. Unal said: "The challenge is to bring the Chinese consumers into the economy." Listen
Albert "Pete" Kyle, the Charles E. Smith Chair Professor of Finance at the Smith School, focused on an excess of savings in China:
"Fifteen years ago, we were talking about a worldwide saving glut. And we had a financial crisis, and people stopped talking about it so much, but I think it's still with us. In particular, China has a high savings rate, and that savings has to go somewhere. It's very difficult for the corporate sector and the industrial sector to deploy huge, huge amounts of savings. It has to go somewhere, and it's been going into real estate and into stocks, driving prices to levels that [are proving to be] unsustainable."
Kyle also pointed to distinctive sociological features of the Chinese population of investors:
"The Chinese stock market is mostly a market of individual investors who are new to stocks. Many have more money than they had in the past, and that leads people to pursue naïve strategies, such as chasing the stocks that are increasing most recently. Naïve investors will think in terms of individual stocks, not the whole market. That's a really bad strategy if everybody in the entire economy is pursuing it at once. It will create bubbles in individual stocks and create a bubble in general.…The Chinese government doesn't like the idea of short-selling, but one of the things short sellers do is protect naïve investors from spending too much in stocks that are overvalued.… So I think the Chinese investors have a lot to learn about investing, and as they become more value based, the market in china will stabilize." Listen
Bill Longbrake, executive in residence at the Center for Financial Policy, thought that the Chinese government had exacerbated the crisis with inept interventions:
"China is the epicenter of the global stock market volatility but it's not because of the Chinese stock market. In fact, if you look at stock prices in China over the last several months, there was considerable volatility, but it was not replicated in the rest of the world until August 11, when China unpegged the yuan to the dollar. It was really bungled. What it did was escalate concern from around the world on the part of investors that perhaps China is significantly slowing — much more so than anticipated."
"Chinese monetary authorities were surprised at the very strong reaction across the globe. It's just been announced that they spent $94 billion over the last month in reserves to stabilize the currency in terms of the dollar … It's really indicative of a major transformation that's underway in the Chinese economy and concerns about the Chinese leadership to manage that transition without there being some real serious fallout."
In an exchange after the meeting, Longbrake expanded on how the devaluation of the Yuan had been mishandled:
"Was it an attempt to stimulate a flagging economy or was there some other reason? Lack of clarity caused confusion and investor concern quickly escalated around the world.… The real reason for unpegging the yuan had to do with China’s goal to qualify as a global currency like the dollar and the euro and become part of the IMF’s special drawing rights (SDRs). One of the IMF’s qualification requirements is that the exchange rates of SDR currencies be market determined. But, Chinese officials didn’t explain this. They compounded confusion further and eroded trust by reversing course quickly and reinstituting currency management. But the damage had already been done. The IMF’s decision was originally scheduled for November of this year; it's now been delayed to October 2016." Listen
Phillip L. Swagel, a professor in international economic policy at the Maryland School of Public Policy, and a CFP fellow, echoed Longbrake's concern that China's leaders had squandered some credibility.
"What strikes me is that the most recent five-year plan from President Xi is actually pretty good. I mean, on paper it's very thoughtful and very complete. And so my real concern is that this episode of volatility — whether it's short lived or longer lived — will either slow down the reform or make the problems longer lasting. There would be an irony if efforts to fix the short term crisis leads to a reversal of beneficial policies."
"It reminds me of the short-selling ban in the United States. We're coming up on the anniversary of the U.S. financial crisis in a couple of days — the failure of Lehmann and then AIG a few days later. There was a ban on short selling which was really not a constructive step. It looked like the U.S. had lost the thread of good policy and that's the sort of thing I worry about going on in China now." Listen
Steve Heston, a professor of finance, took a more abstract view of the crisis, arguing that such upheavals are more common than the press or commenters think —that they need to be taken as a fact of life in the financial system.
"There's going to be another crisis — another large crisis. Unfortunately I can't tell you exactly where or exactly when. I'm going to disagree with my colleague Russ Wermers who say that these things have happened before but not too often. Just this summer we had the Puerto Rican debt crisis. Puerto Rico, a territory of the U.S., said it cannot pay its debts … Last year it was the Greece crisis … Of course there was the 2007-2008 financial crisis, which then prompted the housing crisis. In my experience the crisis of the century occurs every four years. But there are about 25 different countries and currencies where it can occur. Because of efficient markets, we can't predict crises, but we know from history that they happen, if not regularly, at least irregularly pretty often. You can't predict them but you can manage risk." Listen
Banks and investment firms pursue complex strategies to hedge against risk, Heston pointed out — techniques students can learn about in Smith School courses. But if you're a personal investor, how should you manage that risk, one master's-in-finance student asked the panel? Pete Kyle responded:
"Unless you are a professional investor who works for a very professional organization with more than a billion to invest, you should simply index your money, and leave it. Sleep soundly while the Fed is meeting, and don't worry if the market goes up or down."