For a while there, it looked like the doomsayers would be proved right. On July 29, the Shanghai Composite Index lost as much as 7.7% of its value before ending the day down 5% on record-breaking trading volume of $43.3 billion. The sell-off was the largest one-day decline in Chinese stocks in eight months, and set off panic purging in Hong Kong, where the Hang Seng Index lost 2.4%. Even the U.S. got dinged, with the Dow Jones Industrial Average ending the day off by 26 points.
It was a false alarm. Rumors had swept the trading floor that China was going to tighten money supply. That night, the central bank reaffirmed its loose monetary policy that is meant to support economic growth and pledged to refrain from imposing loan quotas to control bank lending. The next day, the Chinese banks that were said to be cutting back on credit denied they would do so. On July 31, the Shanghai index rebounded 2.7%, the biggest rise in two months; China stocks in July rose 15%, the largest monthly gain since 2007.
For now, all is right with the markets again. But last week's Shanghai surprise is a foretaste of what can happen if China's vaunted economic recovery turns out to be a dud. The country's better-than-expected GDP performance is one reason for the current view that the global economy is poised to resume growth, an optimistic reading that in turn is helping fuel investment rallies around the world. But stock markets anticipate the state of the economy and corporate earnings months in advance, so today's euphoria can turn into ashes if the reality falls short of expectations.
Investors are skittish because China's 7.1% second-quarter GDP expansion was due in part to a burst of bank lending, which was up 31% in May and 34% in June from year-ago levels. To date, cumulative loans outstanding have topped $1.1 trillion, far higher than the government's $735 billion target for the year. Most of the money is aimed at funding infrastructure projects under Beijing's two-year, $585 billion stimulus package. But according to government researchers, about $170 billion in bank loans were channeled into the stock market from January to May, which partly explains the 87% rise in Chinese equity values so far this year.
This is all grist for the China skeptics' mill. If low-interest loans meant to keep businesses humming are being diverted to stock speculation, how sustainable is China's recovery? An asset bubble may already be forming. The initial public offerings (IPOs) of Chinese companies in China and Hong Kong are being bid up to eye-popping heights. The $7.3 billion IPO of China State Construction Engineering, which debuted on the Shanghai bourse last week, soared 90% on its first trading day. The property market is sizzling too. New home sales in Shanghai shot up 70% in the first half of the year compared with the same period in 2008.
True, the bulk of bank lending is going to things like roads, bridges and high-speed-train lines that, in theory, should stimulate economic activity and enhance productivity for years to come. But some high-profile works such as the $10.7 billion Hong KongMacau-Zhuhai Bridge have been criticized as unnecessary vanity projects, while others are said to be wastefully duplicative some 300 km of the Shanghai-Nanjing Intercity Railway and the Shanghai-Beijing Express Railway, for example, are overlapping routes. Some local governments have also been discovered to be faking documentation and even entire projects.
The stimulus package includes spending to strengthen social safety nets and boost domestic consumption, such as subsidies for rural consumers to buy selected electronic goods. In an echo of America's wildly popular cash-for-clunkers car program, a new initiative grants consumers in four provinces and five cities 10% discounts if they trade old electronic goods for new ones. The amounts allocated have been criticized as piddling, but their inclusion in the stimulus spending indicates that China's planners recognize the importance of domestic consumption as a driver of growth, given the steep fall in demand for Chinese exports because of the U.S. recession.
The challenge for China is to keep wasteful spending at tolerable levels, to eventually exit the stimulus program without stalling economic recovery, and to tighten monetary policy sooner rather than later to avert runaway asset bubbles but without killing the markets. It's a difficult balancing act, as last week's near meltdown in Shanghai shows. Having gone through the crucible of the 1997 Asian financial crisis, China's planners may be up to the task. Still, they need to be reminded now and again that ham-handed or poorly timed policymaking will hurt not only their economy, but also the rest of the world.