What's driving the Chinese and world stock markets?

The drop in Chinese stock markets has had more than a ripple effect on world markets and threatens to produce a bearish environment everywhere. Are the fears of a spillover and world recession justified? A longer term view suggests otherwise. The world economy can actually benefit from a successful transition in China from an economy emphasizing capital investment, exports and savings to one based on innovation, services and greater consumption. But what are the underlying causes for the current angst, booms and busts? One has to look at Chinese culture and history. A combination of frugality and risk-taking in Chinese culture, combined with negative real interest rates in bank deposits, and amateurism on the part of novice investors and regulators, created huge bubbles (in the Shanghai and Shenzhen stock markets in 2007 and 2015) – bubbles that were bound to deflate.

What Does the Long View of Chinese Markets Reveal?

However, the long view in the graph below shows that (ignoring the bubbles or wild run-ups in 2007 and 2015, the Shanghai stock market has yielded for investors, among the best returns in the world. In the beginning, on January 1, 1991, the Shanghai Composite Index (SHH) was at 130 and, despite a brutal drop after May 2015, was above 2900 in mid-January 2016. This represents a compounded average growth rate (CAGR) of 13.3 percent, about double the rate of returns from the U.S. or European markets over a comparable 25-year period.  This kind of performance should be the envy of the world, and not cause for fears and sell offs elsewhere.

So why the angst and hand wringing? Because the Chinese markets also exhibit distressingly wild swings, in amazingly short time periods. Consider the index’s run up from 1659 on August 6, 2006 to 5955 on October 1, 2007 and the subsequent plunge to 1821 on December 1, 2008 (after the U.S.-induced global recession). More recently, the index was 2117 on August 1, 2014 but was madly propelled upward to 4612 by May 1, 2015, followed by a crash down to 2950 on January 13, 2016.

Investors in the rest of the world are taking the gyrations in the Chinese markets much too seriously, and world markets also turn needlessly bearish – not understanding that the Shanghai or Shenzhen markets are not necessarily good indicators of the fundamentals of the Chinese economy and not understanding the cultural root causes that drive Chinese investors.

Investors in the rest of the world are taking the gyrations in the Chinese markets much too seriously, and world markets also turn needlessly bearish – not understanding that the Shanghai or Shenzhen markets are not necessarily good indicators of the fundamentals of the Chinese economy and not understanding the cultural root causes that drive Chinese investors.

Frugality and Risk-Taking in Chinese Culture

Until a generation ago, most Chinese were poor. Their sages like Confucius or Lao Tze wrote proverbs which made a virtue out of sheer necessity. Mainland Chinese culture today is still in a transition where sudden affluence has not yet erased the frugal habits of the past. Hundreds of millions in China grew up mainly on noodles or rice, with at best tiny portions (under 2 ounces) of meat served no more than thrice a week to accompany the starches. While today they eat better and partake more of flesh, the parsimony of the past lingers in the unusually high savings rate in China. The average American household – depending on the state of the U.S. economy – saves between minus one, and at most four percent of its income. By contrast, the typical “Chinese household socks away about 30 percent of its disposable income, one of the world's highest rates.” According to the World Bank, China has by far the world’s highest Gross Savings Rate (defined as Gross National Income less Consumption). This is something the Chinese government is trying to dampen, and encourage consumption. But changing this millennia-old habit will take a long time. Meanwhile, the huge savings surplus has to go somewhere.

What choices does a family have to invest its savings? Traditionally, gold or valuables would be secreted underground. Yes, there is this newfangled institution call a bank. But local currency (Yuan or RMB) deposit rates only yield between 1.75 percent and 2.5 percent. This sounds marginally better than U.S. savings rates of between zero and 0.9 percent. But actually what banks offer Chinese depositors is a negative return, after factoring in that country’s 6 percent annual inflation rate. What a depositor gets back has less purchasing power than the initial amount he or she deposited with the bank. In short, banks are not at all attractive. Real estate prices have either doubled or quadrupled in the past decade, and everyone realizes that bubble may deflate. Ordinary Chinese cannot convert their local currency (Yuan) and invest outside China because of capital controls imposed by the government. So where to park their money?

There is the Chinese stock market. In April 2015, hairdressers in Shanghai or Shenzhen were telling their customers how they had doubled their investment in just two months between February and May 2015. (In the first half of 2015, by contrast, the S&P 500 barely budged). The mania for a "quick buck" affected all levels of society, down to workers with relatively few savings. 

What choices does a family have to invest its savings? Traditionally, gold or valuables would be secreted underground. Yes, there is this newfangled institution call a bank. But local currency (Yuan or RMB) deposit rates only yield between 1.75 percent and 2.5 percent. This sounds marginally better than U.S. savings rates of between zero and 0.9 percent. But actually what banks offer Chinese depositors is a negative return, after factoring in that country’s 6 percent annual inflation rate. What a depositor gets back has less purchasing power than the initial amount he or she deposited with the bank. In short, banks are not at all attractive. Real estate prices have either doubled or quadrupled in the past decade, and everyone realizes that bubble may deflate. Ordinary Chinese cannot convert their local currency (Yuan) and invest outside China because of capital controls imposed by the government. So where to park their money?

There is the Chinese stock market. In April 2015, hairdressers in Shanghai or Shenzhen were telling their customers how they had doubled their investment in just two months between February and May 2015. (In the first half of 2015, by contrast, the S&P 500 barely budged). The mania for a "quick buck" affected all levels of society, down to workers with relatively few savings. It was a wild run up similar to the tripling of share prices between October 2006 and October 2007, followed by the almost predictable collapse to the original levels by December 2008.

The average American is still much richer than the average Chinese citizen. But because there are so many of them (1.32 billion at last count) even with moderate savings the totals add up. According to Sophia Yan (money.cnn.com), the total value of investments in China’s stock markets can be as high as $ 10 trillion at its peak – although when they crash, the total may be reduced to $ 6 trillion or less. (By comparison the New York Stock Exchange market capitalization was around 19 trillion in 2015).

In sum, there is a lot of pent up money in China, chasing very limited outlets or options. This, plus the fact that most Chinese investors are novices and are willing to take more risks than western investors, explains the wild swings in the Chinese markets.

Moreover, the gyrations in the Chinese stock markets, have little to do with the actual fundamentals of the economy. A study by scholars at the Wharton School and Shanghai Jiaotong University concluded that unlike other nations where stock market indices do correlate with future GDP growth: “The correlation between market returns and future GDP growth for China, however, is much lower and statistically insignificant.”

Risk-Taking Attitudes in Chinese Culture

It seems like a paradox, that Chinese traditions emphasize exemplary frugality, while at the same time Chinese culture and history also laud risk-taking. Studies by Weber & Hsee concluded that when it comes to social interactions, Chinese are indeed conformist and risk-averse. However, in financial transactions, Chinese are significantly bolder than investors in many western nations, something also corroborated in Chinese proverbs which “… seem to provide greater risk-taking advice than American proverbs.”

Gambling also has a long history in China. Desmond Lam, in his “A Brief Chinese History of Gambling” relates how games of chance began as early as the Shang Dynasty (1700 – 1027 BCE). Several games similar to dominoes were created in the Southern Song dynasty (A.D. 1120) and “…a card game (called ‘Ma Diao Pai’) invented during the Ming dynasty (A.D. 1368-1644), became the basis for the mahjong game that we know today.” Gambling became an obsession among high officials as well as common folk. Gambling parlors proliferated in the Qing Dynasty and continue to this day.

Contagious buying during stock market run ups, as well as mass panic selling in market downturns have a history in western markets, admirably recorded in Kindleburger and Aliber’s book, "Manias, Panics, and Crashes." At the height of the mania in Holland’s tulip market (1634-1637) a single tulip bulb sold for as much as a house, only to crash to less than one-hundredth of the peak value two years later. The early introduction of stock markets in the UK saw a similar frenzy, with lower middle class persons risking their life savings in dubious investments such as the South Sea Company (1720) and even buying shares in companies that brazenly refused to disclose what business they would engage in or who the promoters were, except to claim that the promoters were persons of repute. Thousands, from Lords to laborers, were ruined in such mad speculations which followed a predictable pattern of a crazy run up in prices followed by the inevitable crash.

What makes the current situation somewhat worse in China is that the middle class is much bigger (hairdressers in Shenzhen giving stock tips to their customers is a sure sign that the mania has percolated downward to even the working class) and because Chinese brokers have been willing to allow buyers to buy shares on margin (i.e., with borrowed money) which further fuels the drive up in prices. Axiomatically, when the tide of sentiment turns and the market moves downward, margin calls (a requirement that the investor immediately deliver further cash to cover possible losses) accelerate the total market plunge.

Amateurism on the Part of Novice Investors and Regulators

The widespread willingness to gamble is also illustrated in a survey by State Street Corporation (a large financial services firm in New York) that showed that as many as 81 percent of Chinese investors trade at least once a month, which is by far the highest rate in the world . To the nouveau riche in emerging nations, modern finance is a brave new world. With speculative excess that is still untempered by losses, millions from hairdressers and taxi drivers to tycoons have been playing stocks in search for the quick Yuan. The crashes in 2007 and 2015 have not yet deterred new hopefuls from entering this game in China.

Some observers suggest that regulators in China have also acted amateurishly by introducing “circuit breakers” that halt trading if the market index falls by more than 7 percent. The criticism is that such trading halts actually make things worse because they broadcast a panic signal to the media, and induce even more panic selling by investors who otherwise would have stayed on the sidelines. Moreover, that such government intervention, which tries to soften the blow to herd investors, prevents the maturation of Chinese attitudes towards speculation.

The Transition Underway in China and the Rest of the World Economy

Will the behavior of less than one percent of the Chinese population (that invests in shares) drag China and the rest of the world into a recession in 2016? The likelihood of this is low although the Chinese economy is undergoing a somewhat difficult transition. Too much is being read into the slowdown in GDP growth in that nation. For reasons economists do not quite understand, all emerging countries initially grow fast. But as they mature, the growth rate almost always tapers downward. China is still growing at above 6 percent per annum, a remarkable performance that should still be the envy of the rest of the world.

True, the government has an ambitious agenda for the immediate future that includes transitioning from:

• Excess savings to a consumption-led economy
• Export emphasis to domestic market growth
• Mass manufacturing to creative design and services
• Unskilled jobs to skills and creativity in the labor market
• Government spending on infrastructure projects to institutional development
• Growth quantity to growth quality
• Polluted growth to a clean environment and quality of life
• Development on China’s eastern seaboard to balanced regional progress

Even if the Chinese manage to achieve part of this agenda, China and the world will be better for it, and with maturing attitudes amongst Chinese investors, greater stability in stock markets worldwide.

 A version of this article "How Chinese mix of frugality and risk-taking is driving global stock markets wild" appeared in The Conversation on Jan. 19 and Yale Global published "Worries over China's slowdown drive global markets" on Jan 21. The article from The Conversation was republished in The Business Times of Singapore and the Times of India.

Farok Contractor is a distinguished professor of management and global business at Rutgers Business School. His areas of expertise include Asian business, government policies toward foreign investment and globalization. He teaches international business.

Illustration credit: Nanostockk-iStock-ThinkStock