While the stock market is trading near all-time highs, many investors are getting antsy, waiting…
After a trip to his homeland this summer, Northern Illinois University Professor of Finance Lei Zhou wasn’t entirely surprised by the crash of the Chinese stock market this week.
“Everything looked good, people were still spending money, but when you talked to business men you got a much different feeling,” says Zhou.
He spoke to a friend who has worked in the textile industry who told him that sales declined for the first time in 15 years. Another friend in the restaurant industry said that he too was having a down year for the first time in more than a decade. And when he spoke to bankers they told him that banks all across the country were drowning in bad debt.
It is likely that factors such as these, which speak to the state of the Chinese economy, rather than its stock market, were what sent investors across the globe into a tizzy this week, says Zhou, who is the Jones, Diedrich, Minnie Professor of Finance in the NIU College of Business, where he has taught since 1993.
“Back in July, when the Chinese markets dropped, nobody reacted,” he says. “That market had doubled in a little more than a year, so it was due for a correction. What made things different this time is that in the last two weeks there were a couple of pieces of bad economic news coming out of China.”
The first was a report that a manufacturing index had declined. The second piece of bad news came when the Chinese government announced that it was devaluing its currency.
“It was only 2 or 3 percent, but the Chinese government tries to keep their currency as stable as possible,” Zhou says. “So when they devalued it, in an effort to encourage exports, Wall Street analysts took that as a signal that the government knew something that they did not, and that it wasn’t good news.”
When Chinese stocks tumbled, the U.S. markets reacted with a vengeance. Stocks plummeted more than 1,000 points in four minutes. Although, Zhou speculates, some of that might also may have been U.S. investors using the Chinese collapse as an excuse to do some profit taking in advance of an anticipated rise in interest rates later this year.
By the close of trade Wednesday, U.S. markets had already recovered most of their losses, but investors should expect more volatility, says Zhou.
The problem is the massive debt taken on by China in recent years, largely to finance infrastructure and other fixed asset investments. In an attempt to offset that debt, the government began heavily promoting the stock market, setting off a bull run that doubled the market capitalization. The plan, says Zhou, was to let heavily indebted corporations and banks recapitalize and reduce their leverage through issuances of more equity. Now that the market has crashed, however, Zhou expects that it will be a long time before investors get over their wariness. The Chinese government needs to come up with a Plan B to deal with the huge debt problem.
He is hopeful that China will be able to turn things around through fiscal policy. In fact, his advice to the typical investor is that now might be a good time to invest, as many stock prices are down and valuation is more reasonable.
Even if China struggles, Zhou believes U.S. markets are large enough and diverse enough that troubles in the world’s second largest economy will be far from crippling. In addition, lower commodity prices, due to economic slowdown in China, could help the US economy. “The next time you pump gas at less than $3 a gallon, you can, in part, thank the economic woe in China.”
One thing that does concern him, however, is if the financial crisis in China leads to social unrest.
“Here in the U.S., and most other countries, there is a relief valve when people get angry. For instance, when the stock market crashed in 2008, we voted the Republicans out of office,” says Zhou. “In China, they don’t have that safety valve. The chances of social unrest are small, but if the Chinese economy goes off the rails, and it leads to large scale protests and political instability, it could get much uglier than this. That is the time to take your money off of the table.”