© 2016 Prof. Farok J. Contractor, Rutgers University
Life in China – A Gambling House and Opium Den at Macao
The drop in Chinese stock markets has had more than a ripple effect on world markets—and threatens to produce a bearish environment everywhere. Are the fears of a spillover and world recession justified? A longer-term view suggests otherwise. The world economy can actually benefit from a successful transition in China from an economy emphasizing investment, exports, and savings to one based on innovation, services, and greater consumption.
But what are the underlying causes for the current angst, booms, and busts? Chinese culture and history. A combination of frugality and risk-taking in Chinese culture, combined with negative real interest rates in bank deposits and amateurism on the part of novice investors and regulators, created huge bubbles in the Shanghai and Shenzhen stock markets in 2007 and 2015. And the bubbles were bound to deflate.
NOTE: A version of this post was published as Frugality and risk-taking in Chinese culture make for heady mix – and gyrations for global markets by YaleGlobal, Yale University’s online publication, on January 21, 2016. It was republished in the Times of India online blog as China’s wildly swinging market: Don’t worry, it’s just novice investors playing with a lot of savings on January 23, 2016.
What Does the Long View of Chinese Markets Reveal?
The long view in the graph below shows that, ignoring the bubbles or wild runups in 2007 and 2015, the Shanghai stock market has yielded for investors among the best returns in the world. In the beginning, on January 1, 1991, the Shanghai Composite Index (SHH) was at 130, and, despite a brutal drop after May 2015, it was above 2900 in mid-January 2016. (See Figure 1.) This represents a compounded average growth rate (CAGR) of 13.1%, about double the rate of returns from the US or European markets over a comparable 25-year period. This kind of performance should be the envy of the world, not a cause for fears and sell-off elsewhere.
So why the angst and hand-wringing? Because the Chinese markets also exhibit distressingly wild swings in amazingly short periods. Consider the index’s runup from 1659 on August 6, 2006 to 5955 on October 1, 2007, and then the subsequent plunge to 1821 on December 1, 2008 (after the US-induced global recession). More recently, the index was 2117 on August 1, 2014, but was madly propelled upward to 4612 by May 1, 2015, followed by a crash to 2950 on January 13, 2016.
Figure 1: Taking the Long View of the Shanghai Market
Investors in the rest of the world are taking the gyrations in the Chinese markets much too seriously, and world markets also turn needlessly bearish—not understanding that the Shanghai or Shenzhen markets are not necessarily good indicators of the fundamentals of the Chinese economy, and not understanding the cultural root causes that drive Chinese investors.
Frugality and Risk-Taking in Chinese Culture
“I have . . . precious things which I hold fast and prize. The first is gentleness; the second is frugality. . . .” ― Lao Tzu
“. . . he who will not economize will have to agonize.”
Until a generation ago, most Chinese were poor. Their sages Lao Tzu and Confucius wrote proverbs that made a virtue of sheer necessity. Mainland Chinese culture today is still in a transition where sudden affluence has not yet erased the frugal habits of the past. Hundreds of millions in China grew up mainly on noodles and rice, with at best tiny portions (under 2 ounces) of meat (or fish) served no more than three times a week to accompany the starches. While today they eat better and partake more of animal flesh, the parsimony of the past lingers in the unusually high savings rate in China.
The average American household—depending on the state of the US economy—saves between –1% and, at most, 4% of its income. By contrast, the typical “Chinese household socks away about 30% of its disposable income, one of the world’s highest rates.” According to the World Bank, China has by far the world’s highest gross savings rate (defined as gross national income less consumption). This is something the Chinese government is trying to dampen while it encourages consumption. But changing this millennia-old habit will take a long time. Meanwhile, the huge savings surplus has to go somewhere.
What choices does a Chinese family have for investing its savings? Traditionally, gold or valuables would be secreted underground. Yes, there is this newfangled institution called a bank. But local currency (renminbi [RMB] yuan) deposit rates yield only between 1.75% and 2.5%. This sounds marginally better than US savings rates of between 0% and 0.9%. But what banks actually offer Chinese depositors is a negative return, after factoring in that country’s 6% annual inflation rate. What a depositor gets back has less purchasing power than the initial amount he or she deposited with the bank. In short, banks are not at all attractive. Real estate prices have either doubled or quadrupled in the past decade, and everyone realizes that bubble may deflate. Ordinary Chinese cannot convert their local currency (RMB yuan) and invest outside China because of capital controls imposed by the government. So where to park their money?
Then there is the Chinese stock market. In April 2015, hairdressers in Shanghai or Shenzhen were telling their customers how they had doubled their investment in just two months between February and May 2015. (In the first half of 2015, by contrast, the S&P 500 barely budged.) The mania for a “quick yuan” affected all levels of society, down to workers with relatively few savings. (See Figure 2.) It was a wild runup similar to the tripling of share prices between October 2006 and October 2007, followed by the almost predictable collapse to the original levels by December 2008. (See Figure 1.)
Figure 2: Shanghai Composite Index vs. S&P 500 – First Half of 2015
Source: Sophia Yan (money.cnn.com), June 15, 2015
The average American is still much richer than the average Chinese citizen. But because there are so many of them (1.32 billion at last count), even with moderate savings the Chinese totals add up. According to Sophia Yan (money.cnn.com), the total value of investments in China’s stock markets can be as high as $10 trillion at its peak—although when they crash, the total may be reduced to $6 trillion or less. (By comparison, the New York Stock Exchange market capitalization was around 19 trillion in 2015.)
In sum, China has a lot of pent-up money chasing very limited outlets or options. This, plus the fact that most Chinese investors are novices and are willing to take more risks than western investors, explains the wild swings in the Chinese markets.
Moreover, the gyrations in the Chinese stock markets have little to do with the actual fundamentals of the economy. A study by scholars at the Wharton School and Shanghai Jiaotong University concluded that unlike other nations where stock market indices do correlate with future GDP growth, “The correlation between market returns and future GDP growth for China, however, is much lower and statistically insignificant.”
Risk-Taking Attitudes in Chinese Culture
“Pearls don’t lie on the seashore. If you want one, you must dive for it.”
― Chinese proverb
It seems like a paradox: Chinese traditions emphasize exemplary frugality, while at the same time Chinese culture and history laud risk-taking. Studies by Weber & Hsee concluded that when it comes to social interactions, Chinese are indeed conformist and risk-averse. However, in financial transactions, Chinese are significantly bolder than investors in many western nations, something also corroborated in Chinese proverbs, which “. . . seem to provide greater risk-taking advice than American proverbs.”
Gambling also has a long history in China. Desmond Lam, in his A Brief Chinese History of Gambling, relates how games of chance began as early as the Shang Dynasty (1700–1027 BCE). Several games similar to dominoes were created in the Southern Song dynasty (A.D. 1120) and “. . . a card game (called ‘Ma Diao Pai’), invented during the Ming dynasty (A.D. 1368-1644), became the basis for the mahjong game that we know today.” Gambling became an obsession among high officials as well as common folk. Gambling parlors proliferated in the Qing Dynasty and continue to this day.
Contagious buying during stock market runups, as well as mass panic selling in market downturns, have a history in western markets, admirably recorded in Kindleburger and Aliber’s book, Manias, Panics, and Crashes. At the height of the mania in Holland’s tulip market (1634–1637), a single bulb sold for as much as a house, only to crash to less than one-hundredth of the peak value two years later. The early introduction of stock markets in the UK saw a similar frenzy, with lower-middle-class persons risking their life savings in dubious investments such as the South Sea Company (1720), and even buying shares in companies that brazenly refused to disclose what business they would engage in or who the promoters were—except to claim that the promoters were persons of “repute.” Thousands, from lords to laborers, were ruined in such mad speculations, which followed a predictable pattern of a crazy runup in prices followed by the inevitable crash—as we see for China (Figure 1 above) during 2007 and 2015.
What makes the current situation somewhat worse in China is that the middle class is much bigger (hairdressers in Shenzhen giving stock tips to their customers is a sure sign that the mania has percolated downward to even the working class), and Chinese brokers have been willing to allow buyers to buy shares on margin (i.e., with borrowed money), further fueling the drive-up in prices. Axiomatically, when the tide of sentiment turns and the market moves downward, margin calls (a requirement that the investor immediately deliver further cash to cover possible losses) accelerate the total market plunge.
Amateurism on the Part of Novice Investors and Regulators
The widespread willingness to gamble is also illustrated in a survey by State Street Corporation (a large financial services firm in New York) that showed that as many as 81% of Chinese investors trade at least once a month, which is by far the highest rate in the world. To the nouveau riche in emerging nations, modern finance is a brave new world. With speculative excess that is still untempered by losses, millions of people from hairdressers and taxi drivers to tycoons have been playing stocks in search for the quick yuan. The crashes in 2007 and 2015 have not yet deterred new hopefuls from entering this game in China.
Some observers suggest that regulators in China have also acted amateurishly by introducing “circuit breakers” that halt trading if the market index falls by more than 7%. The criticism is that such trading halts actually make things worse because they broadcast a panic signal to the media and induce even more panic selling by investors who otherwise would have stayed on the sidelines. Moreover, such government intervention, which tries to soften the blow to herd investors, prevents the maturation of Chinese attitudes towards speculation.
The Transition Under Way in China and the Rest of the World Economy
Will the behavior of less than 1% of the Chinese population (that invests in shares) drag China and the rest of the world into a recession in 2016? The likelihood of this is low, although the Chinese economy is undergoing a somewhat difficult transition. Too much is being read into the slowdown in GDP growth in that nation. For reasons economists do not quite understand, all emerging countries initially grow fast. But as they mature, the growth rate almost always tapers downward. China is still growing at above 6% per annum, a remarkable performance that should still be the envy of the rest of the world.
True, the government has an ambitious agenda for the immediate future that includes transitioning from:
- Excess savings to a consumption-led economy
- Export emphasis to domestic market growth
- Mass manufacturing to creative design and services
- Unskilled jobs to skills and creativity in the labor market
- Government spending on infrastructure projects to institutional development
- Growth quantity to growth quality
- Polluted growth to a clean environment and quality of life
- Development on China’s eastern seaboard to balanced regional progress
Even if the Chinese manage to achieve part of this agenda, China and the world will be better for it. And with maturing attitudes among Chinese investors, greater stability will be evident in stock markets worldwide.