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Bearish in Beijing

Author: Lee Hudson Teslik
April 4, 2008

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Given the turmoil in U.S. equity markets, it would be easy to overlook the fact that Chinese stocks have suffered substantially worse losses in recent months. Since October 2007, the Dow Jones Industrial Average has shed roughly 10 percent of its value. China’s Shanghai Composite Index, which tracks the large blue-chip firms listed on the Shanghai stock exchange, has lost nearly 40 percent (IHT) in the same time period. Some analysts say the downturn can be brushed off as mere “paper losses”—a return to sanity following an unrealistic run-up in 2006 and 2007. China’s underlying economy still shows strong growth, and even accounting for the stock market downturn, International Monetary Fund (IMF) projections still put the country’s annual growth rate at over 7 percent, a blistering pace by global standards. But even if China keeps growing, Shanghai’s stretched stock market, burdened by restrictions on international investment, still poses problems for Chinese policymakers.

Why are Chinese stocks falling? One chief fear cited by an analyst in China Daily is that a U.S. economic downturn might weaken global economic prospects—and particularly those of major exporters like China. The Wall Street Journal notes a more immediate connection already under way. As international hedge funds saw profits dwindle during the past year, they were forced to draw down their holdings in other areas. Many had invested in China and were forced to edge out of these positions, broadly driving down the prices of Chinese equities.

A number of other concerns have bubbled up. Beijing announced inflation hit 8.7 percent (Bloomberg) in the twelve months ending February 2008. The Chinese government has singled out inflation as its primary legislative concern for 2008 (BBC), and price pressure now represents a major worry for investors in China. Rising global energy prices have worsened inflation globally, but have taken a particularly harsh toll on China given its rapidly growing hunger for oil, natural gas, and coal. The Economist says the country may soon be forced to “learn to do more with less”—not something businesses in an emerging economy are keen to hear.

China and U.S. stock indexes chart

Few analysts expect China’s stock slump will cause the country’s economic growth to derail. But some experts say the recent dip highlights problems Beijing needs to address to integrate its equity markets globally and prevent future turmoil. First, China has struggled to cope with a flood of investment from its own citizens. The Associated Press reported in 2007 that record numbers of first-time Chinese investors were pouring money into Chinese shares as the Shanghai index surged ever higher. Analysts say Beijing fed the domestic bubble with restrictions on incoming and outgoing investment. A growing Chinese middle class found itself restricted to Chinese investments, they say, and pushed the Shanghai index to dizzying heights.

The Journal article says frustrated first-time investors pose a potentially greater problem if they move to challenge China’s central government. China is preparing new market regulations to try to deal with the problem, though the New York Times notes that Beijing’s government has taken a mixed view toward market interventions. An editorial in China Daily calls for a “multi-layered stock market” that can meet the needs of Chinese businesses while preventing investment flows from China’s massive population from leading to bubbles. Yet such regulations must make sure not to overreach, the article cautions. As rough as the market downturn has been for investors, it says, a glut of small and midsized Chinese businesses are still clamoring for money, and the greatest economic calamity would be if regulators curtail the flow of investment.

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