China’s stock market has been in a free fall since the beginning of the year, wiping out more than $1 trillion in market capitalization in days. This is the worst start to a year for the world’s second-largest economy, and it has sparked fears of a global slowdown and a financial crisis.
What is behind this dramatic plunge? There are several factors at play, but the main ones are:
The coronavirus outbreak: The deadly virus that originated in Wuhan, China, has infected more than 20,000 people and killed over 400, as of February 4. The outbreak has disrupted travel, trade, and business activity in China and beyond, as authorities impose lockdowns and quarantines to contain the spread. The impact on China’s economy, which accounts for about 16% of global GDP, is expected to be significant and lasting.
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The trade war with the US: Although China and the US signed a phase one trade deal in January, the trade tensions between the two countries are far from over. The deal only covers some of the issues that have been at the center of the dispute, such as intellectual property rights, agricultural purchases, and currency manipulation.
Many other thorny topics, such as industrial subsidies, cyber security, and human rights, remain unresolved. The trade war has already taken a toll on China’s exports, manufacturing, and investment, and it could escalate again if either side fails to comply with the deal’s terms.
The debt problem: China’s debt-to-GDP ratio has soared to more than 300%, one of the highest in the world. Much of this debt is held by state-owned enterprises (SOEs), local governments, and shadow banks, which are less regulated and more risky than traditional banks.
The high level of debt poses a threat to China’s financial stability and growth potential, as it increases the risk of defaults, bad loans, and asset bubbles. The government has been trying to rein in the debt problem by tightening credit conditions and cracking down on shadow banking, but this has also slowed down economic activity and reduced liquidity in the market.
The structural slowdown: China’s economy has been slowing down for years, as it transitions from a low-cost manufacturing hub to a more consumption-driven and service-oriented economy.
This is a natural and inevitable process for any developing country, but it also means that China can no longer rely on cheap labor, massive infrastructure spending, and export-led growth to fuel its expansion. China’s growth rate fell to 6.1% in 2019, the lowest in nearly three decades, and it is expected to drop further this year.
These factors have created a perfect storm for China’s stock market, which has lost about 10% of its value since January 17. The market is also highly volatile and speculative, as it is dominated by retail investors who tend to follow herd behavior and react to news and rumors.
The government has intervened several times to prop up the market, by injecting liquidity, cutting interest rates, suspending trading fees, and banning short selling. However, these measures have had limited effect, as investors remain pessimistic about the outlook for China’s economy and corporate earnings.
The slump in China’s stock market has also had spillover effects on other markets around the world, especially those that are closely linked to China’s trade and supply chains. The MSCI All Country World Index, which tracks stocks across 49 countries, has fallen by about 4% since January 17. The US stock market has also suffered its worst week since August last year, as investors worry about the impact of the coronavirus outbreak on global growth and demand.
The question now is whether China’s stock market crash will trigger a broader financial crisis or a recession. While some analysts have drawn parallels with the 2008 global financial crisis or the 1997 Asian financial crisis, others have argued that China’s situation is different and more manageable.
They point out that China still has ample policy tools and fiscal space to stimulate its economy and support its financial system. They also note that China’s capital controls limit the outflow of money and prevent a currency crisis or a balance of payments crisis.
However, there are also risks and challenges that could worsen China’s situation or hamper its recovery. For instance:
The coronavirus outbreak could worsen or last longer than expected, causing more human suffering and economic damage.
The trade deal with the US could unravel or face implementation difficulties, reigniting the trade war and hurting business confidence.
The debt problem could escalate or trigger a wave of defaults or bankruptcies among SOEs, local governments, or shadow banks.
The structural slowdown could deepen or expose more weaknesses in China’s economic model or governance system.