Why you shouldn’t sweat China’s market woes

A lot of people have been asking what the heck happened in China this last couple of weeks, and whether it’s a problem for us.

Let’s answer the second question first: no. The sharp correction in the Chinese stock market is not a problem for us. It has, admittedly, been a big drop: the Shanghai Composite Index market peaked on June 12, and by July 2 it had dropped 28 percent, erasing $2.4 trillion in paper wealth. But there’s no immediate effect on American investors: US investor exposure to Chinese equities is minimal, if only because China is still regarded as the Wild West by most US financial managers, and rightly so, given the lack of transparency of that country’s institutions, legal process and corporations. To give you an idea of how low our collective exposure is, Bank of America/Merrill Lynch says foreign investors own less than 1 percent of mainland China stocks.

For a definition of a correction, check this short, amusing video. There’s a rollercoaster!

But won’t there be a knock on effect here? Probably not, and if there is, it will likely be minimal. It’s true that most of the investors involved in the Chinese stock market are individuals, not institutions, but less than 15 percent of household assets are invested in the market there. As the Economist notes, that’s why consumption wasn’t much affected by the run-up in shares, and why it won’t be much affected by this plunge. When it comes to the stock market, the stakes are relatively low for the Chinese consumer, and losses will be concentrated among a few unfortunates.

A bigger issue could arise in the loan market in China. Most of the surge in Chinese stocks was caused by investors buying on margin – borrowing to buy shares, in other words. Losses on those loans might freeze the shadow lending market, and if that happens, the entire loan market might ice up, crimping spending and growth. It could also puncture the real estate market, which looks particularly bubblicious right now. If that happens, and there’s a recession, it will affect all of China’s trading partners, including the US. Some people are making dark predictions of a recession already, but I’d say they’re jumping the gun.

Is there a systemic risk to the Chinese finance and banking system that could bring China to its knees and trigger a global financial collapse? Probably not. Remember that figure about individuals being the main players in the market? Banks simply aren’t that exposed: domestic equities account for about 1.5 percent of total assets in the banking system.

Which leaves the first question: what happened?

The short answer is that people who invested in the stock market got overextended. They borrowed way too much to buy shares, and pumped those shares way higher than they every should have been. It was a classic bubble, with investors buying shares simply because they were going up, rather than looking at their fundamentals, and it was bound to burst at some point. As soon as people lost their nerve and realized prices were too high, they started to sell. That set off a wave of selling that was exacerbated by companies who lent investors money calling their loans. That sparked even more selling, and the next thing you know, the market is down nearly 30 percent in three week.

But let’s not forget, even with that correction, the market is still up more than 80 percent for the last 12 months, which isn’t too shabby. A handful of people have lost a lot of money, and the Chinese government has lost some face, but that’s really it. The show will go on.