The second largest economy in the world, after the USA, is China, an economy that has been growing rapidly for the past twenty years due to numerous competitive advantages – among them, cheap energy and low salaries – which have helped to create an environment of low production costs. Following this massive growth, the communist government of China gave the order to improve infrastructure in order to stimulate the economy even further. However, the Chinese economy is now bleeding. In recent years their GDP kept growing at a rate between 7% and 8%, lately slowing down to about 3%. In spite of the fact that this is still growth, it is a not a good forecast for China’s economy. According to the efficient market hypothesis, expectations are directly affecting the prices of stocks. The downward expectations, in accordance with the declining growth rate, are making the investors afraid that the growth will decrease even more and may eventually change into a fall. This can be seen in the stock market where investors sold loads of securities leading to a sharp decline of the Chinese indices. What is causing this, and is it possible for economists to prevent a second credit crisis?
China’s competitive advantages have been eroded and China is the culprit itself. Due to the rising economy, China’s formerly low, now rising salaries have lost competitiveness, especially in manufacturing. At the same time, their neighbors – like India and Pakistan – have kept their low wages at a level comparable with late 1990’s China. As a result, the production costs for China at this moment are relatively high. They certainly are high if you compare the average quality/price ratio. Especially if you look at other Asian countries, where the salary range for employees is similar, but quality is better. This means that for the big production companies from the United States and Europe, it is becoming more profitable to move their activities elsewhere. Any economist forecasting in the early 1990s, or even later, such a turn of events would become the laughingstock of their peers.
Another reason for the declining economy is again caused by China itself; in China there are too many buildings, 65 million new apartments are lying vacant. The local people are still not wealthy enough to buy these apartments, despite the rising salaries. This real estate bubble in China is getting bigger and bigger until it may burst eventually. With any luck it will not happen, but if it does, it will hopefully not have the same effect as it did in the financial crisis of 2008 in the United States. If the real estate business does not change, the bubble will burst because there are simply too many buildings. This means that supply will far exceed demand and, therefore, the prices will go down. When the prices decrease, people lose money on their relatively expensive investments. Nevertheless it is the Chinese central bankers’ and economists’ duty to intervene and prevent a tragedy. Their current approach is lowering the interest rates, in a hope that people will borrow more money to purchase houses. Moreover, the currency of China, Yuan, has recently depreciated against the US dollar. The Chinese central bank lowered the value of the Yuan by issuing more currency to lower the interest rate. The Yuan does not have a floating exchange rate like other currencies, but a fixed one. This means that the currency is pegged to another currency. The lower value of the renminbi (another name for the Chinese currency) can translate into it being more expensive for Chinese companies to buy abroad and cheaper for foreign companies to buy in China. Of course, you could say that they are a little too late with the intervention and that they should have taken the experience of the United States in 2008 into account. However, they did not expect the declining growth of the economy.
Naturally, companies located in China, as well as the Chinese citizens, have been impacted the most. However, it has also had an effect internationally. The most important index of China – the Shanghai Stock Exchange – lost almost half of its value from June to August, which is a considerable amount for such a short term. On the 9th of June, the index was at 5.1113,534 points and on the 24th of August, the index was at 2.279,836 points. International investors, including those from Europe and the United States, lost money because of their investments in Chinese stocks and other securities. Primarily the 24th of August – labeled Black Money – caused a lot of panic on the stock markets worldwide. For instance, the stock index of the Netherlands (AEX) lost that day the gains it had made over the year. On the 2nd of January the AEX was at 422,28 points and grew to 508,34 points on the 4th of August. On the 24th of August the AEX was at 419,68 points. Other indices such as the Dow Jones, NASDAQ, S&P500, FTSE100, CAC40 also lost a huge amount of value.
Investors were experiencing the same fear as they did in 2008 when the stock market in the United States was in a free fall because of the bankruptcy of Lehman Brothers. Fortunately, the investment banks, insurance companies, hedge funds and other huge investors were well-diversified and not involved in particularly complex derivatives such as credit default swaps, where investment banks made it possible to trade in mortgages and therefore made them more liquid. Therefore, unlike in 2008, the damage was manageable.
The government of China encouraged the citizens, especially the youth, to invest in stocks and, as a result, most of them practically lost all of their money. The government needed that amount of people to invest in stocks and other securities in order to pump more money into the financial markets, and, therefore, into the economy. Unfortunately, because of the communist behavior of the government, they own a lot of businesses that are labeled as ‘state businesses’. As a result, the government is as good as safe for financial distress, while the population becomes the victim if the things go wrong.
A little fun fact about the bearing market in China: a hedge fund from London has made millions of profit because they had short positions in Chinese stocks. If you have short position, this means that you are expecting a fall in the share price. For example, you sell stock X for 10$ and when it falls to 8$ you buy stock X back for 8$. If you sold 10 pieces of stock X, you received 100$. You also bought back 10 pieces of stock X but you only paid 80$. This means that you have a profit of 20$. This strategy of investing in stocks can be very risky, because the profit you could make is limited while the loss is unlimited. A stock cannot go below 0$ but in theory it can grow infinitely. It is hard to say if this is just luck or if it is because the hedge fund manager happened to be very skilled.
Every financial institution in the world must take into consideration the economic situation of China. The volatility of the stocks is huge, the volatility of the currency is huge and the volatility of other securities such as bonds is also huge. So will the second financial crisis be made in China? Maybe it will, but the causes will not be too big investments or complex derivatives. It will be, more fundamental, bursting bubbles or bad interventions. Although a major financial crisis has thus far been prevented, there must be continuous attention on the Chinese economy in order to prevent potential problems.