While the high volatility in Chinese stocks recently has drawn a great amount of attention from the financial press as well as the ruling party in Beijing, the threat a bear market on the Shanghai Exchange poses to the global economy may be overstated.
Even though the Chinese stock market has dropped 30% since June, it's still up 14.5% for the year, compared to -0.45% for the Dow and +2.4% for the S&P 500.
What has caused the (over)reaction from the Chinese government is more a matter of political credibility than economic necessity. State-run media have been urging citizens to buy into the stock market to build a new prosperity. With things recently turning sour, public sentiment could turn against the ruling Communist Party. A recent Wall St Journal report noted that "mainland bourses are abnormally speculative, restricted and unconnected to the real economy when compared with other stock markets." The pain of trillions of dollars of stock losses hasn't really affected the average Chinese citizen, as only 7% of the population are invested in the stock market.
It's the Economy, Stupid
A greater peril to China, and to the world economy in general, is a stumble in market reforms as the government attempts to move the nation from dependence on exports and government spending to a consumer-driven economy that allows private enterprise. This is a rocky path, filled with political and economic pitfalls. Although the Chinese middle class is growing, state-own industrial and financial sectors provide most of the muscle. GDP in China is projected to growth at 7% this year. While most of the industrialized world would love to see growth anywhere near that, it represents a 25-year low for China. This illustrates how difficult the path ahead will be.
Past growth in China has been fueled by massive amounts of debt, and a blind eye towards the unprofitability and excess capacity of state-run industries. As exports decline and growth slows, that tsunami of toxic debt looms over the country. Forbes quoted hedge fund billionaire Paul Singer as saying “This is way bigger than subprime.” However, others believe that Beijing's intervention in the stock market, using billions of dollars of government cash reserves to stabilize the market, is a sign of how any "Chinese Lehman Moment" will be handled. Since so many large banks are still owned by the government, it is speculated that the contagion can be contained by the government tapping into nearly $4 trillion in cash reserves.
The Piper Must Be Paid
However, the Communist Party has been pushing off substantive economic reforms, either from an aversion to political costs, or getting distracted while putting out "brush fires" such as the stock market slump. Further delays in reform could drag economic growth in China to levels where the spillover into other major markets become a global concern. Emerging market nations have already been substantially damaged by the slump in commodity prices this summer.
We could see a "perfect storm" of a Chinese credit implosion and recession fueling an already-strong dollar to suppress American exports to the point where the U.S. is dragged down as well. With benchmark interest rates already practically zero, central banks will have few options for come to the aid of the markets.