26 August 2015

Making Sense of China's Market Volatility

The dramatic decline in share prices in China in recent days has raised concerns that the Chinese economy is entering into a period of significantly lower rates of growth and higher rates of volatility.  However, it remains to be seen if these dramatic changes in share prices in China were the result of actual economic changes or if they were simply an irrational response by investors in China to some economic policy changes made by the Chinese government, most notably the recent devaluation of the yuan.  While it is clear that the expansion of the Chinese economy is slowing, this slowdown had been forecast for some time, so investors should not have been surprised by the fact that growth has slowed this year.  Nevertheless, this recent volatility is raising concerns around the world that this crucial pillar of global economic growth is suddenly wobbling.

Economic data coming out of China has suggested that the Chinese economy was in the midst of a slowdown, but it wasn’t until the Shanghai Composite (China’s main stock exchange) lost 16% of its value earlier this week that the situation in China really gripped the world’s attention.  While share prices in China have steadied somewhat since this sharp decline, they remain more than 40% below their levels from June 2015.  However, it is important to remember that the Shanghai Composite had risen by more than 60% between March and June 2015, even as economic data released during that period showed that the Chinese economy was slowing.  As such, it is clear that a share price bubble was forming in China and that share prices would most likely fall as more disappointing economic results emanated from China.  The recent sharp fall in share prices in China is thus largely a market correction that should have been expected.

While the fall in share prices in China has dominated the headlines in recent weeks, a host of other data releases is giving a clearer picture of the actual health of the Chinese economy.  At the top end, the 7.0% GDP growth rate recorded in the first six months of this year has been met with much skepticism by economists, with many believing that the Chinese economy actually expanded by around 5% during this period.  Meanwhile, export revenues have fallen in recent months (they declined by 8.0% year-on-year last month) and this has had a significant impact on China’s manufacturing sector, which has seen manufacturing activity fall to a six-and-a-half-year low this summer.  In contrast, the volatility on China’s stock market has yet to have had a major impact on China’s rapidly expanding domestic market, as consumer confidence levels in China remain relatively high, thus shielding the Chinese economy from an even greater slowdown.

The recent economic volatility in China is a sign that the Chinese economy is continuing its shift away from being an export- and investment-driven economy to one that is increasingly driven by domestic demand.  The fact that this massive transition is creating some degree of volatility should not come as a surprise as there will inevitably be winners and losers in this transition.  For the global economy, the losers may end up being those commodity exporters that depended upon ever-increasing demand in China for much of their economic growth.  On the other hand, exporters focusing on China’s fast-growing domestic market are likely to benefit over the longer-term from the changes underway in China.  It was clear that the days of double-digit economic growth rates in China would come to an end and that Chinese economic growth rates would settle into a more sustainable level.  That there is some pain accompanying this transition should have also been foreseen.  Moreover, despite the growing uncertainty in China, a hard-landing for the Chinese economy remains highly unlikely.