Measuring China’s Progress

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As China makes its gradual transition from communism to capitalism and from poverty to prosperity, it can be easy to lose track of how much progress China has made.  The recent stock market rise and fall is yet another reminder that China is still a relatively poor country in the early stages of development. 

You’re in real China now!

As we turned from a modern, six-lane thoroughfare onto a small, windy road in a second tier city in China, conversation in the van came to a screeching halt.  The six foreigner business executives in the van had been in China for a week but had seen nothing like this–clothes drying on a cord strung between trees, sparks flying from a shirtless man sitting on the sidewalk grinding a tool, and duck carcasses in a restaurant window.  There was silence for a moment as they took it all in.  “Where are we?” said one.  After a brief pause, one of the Chinese in the van, a colleague of theirs, said slyly, “You’re in real China now.”  The rest of us chuckled.

Is China rich or poor?

With the world’s second largest economy, the largest car and cell phone markets in the world, the largest holdings of foreign exchange reserves, and more millionaires, skyscrapers, and luxury cars than you can possibly count, it is easy to lose sight of a fundamentally important point—China is still a poor country in the early stages of economic development.  After spending a week in luxury hotels in the centers of big cities, the executives in that van didn’t fully appreciate that point until they saw the reality of it up close and personal.  The same could probably be said of those watching recent events relative to China’s stock market.

Leverage, speculation, and government intervention

Within a 12 month time period, margin debt outstanding rose by 500% and the stock market doubled.  The market then fell by roughly 30% over a week or so, with much of the trading done by relatively unsophisticated retail investors.  The government then threw everything but the kitchen sink at the market in an attempt to stem the slide, which seems to have worked for now.

An Immature Market

Of course, a market boom and bust driven by liquidity, leverage, and speculation which results in strong government measures to support the market would never happen in a mature, sophisticated economy like the US.  (Yes, I did say that.  Yes, I am joking.)  Obviously we have bubbles, too, and leverage usually plays a role.  But as a developing country, while China’s stock market followed a pattern that is familiar to us, it also reached extremes within that pattern that are not generally found in a more mature market.

For example, liquidity might drive America’s markets at times, but a five-fold increase in margin debt in one year is highly unusual.  Booms also occur in a mature market, but doubling in one year is also highly unusual.  America has also seen the influence of “day traders” whose inexperienced speculation helped fuel the dotcom boom.  But retail investors own less than 30% of equities in the US, versus 85% in China.  Fewer professional investors in a less mature market—it makes sense.

An Over-Active Government

But the biggest difference might lie in the government reaction.  In the US trading might be suspended for a brief period.  The Federal Reserve will certainly inject liquidity into the economy to make it easier to buy shares.  But in China, state-owned banks were ordered to lend to a government agency that then bought shares to support the market.  Trading in the shares of at least 50% of listed companies was suspended for two weeks.  Some investors, such as state-owned enterprises, were told they could not sell shares.  It was announced that the police were on alert to detain anyone engaged in illegal short selling.  Plus, while the market was rising, some Chinese officials and official media outlets served as cheerleaders for the run up, something that is generally frowned upon in a place like the US.  So while throwing the kitchen sink at a falling stock market isn’t unusual, because China isn’t as free market oriented as the US, their kitchen sink is much bigger than America’s.

China is not a completely free market, but it is moving that way

The China haters and doubters, of which there is no shortage, will seize on this to point out that China is still “communist” and will always act communist when it is to their advantage to do so.  They are correct to a degree—China’s government remains heavily involved in the economy.  But they are more incorrect because they ignore the progress China has made toward the free market, which is substantial, if not complete.

Companies need to understand how much progress China has made

For those looking to do business in China, whether as an investor or in an operating company, it is imperative to keep this point in mind.  Some parts of the Chinese economy are very free market oriented.  Some parts are not.  Other parts are in between.  Overall the economy is still relatively under-developed and government over-involvement or over-reaction is a persistent risk.  This hasn’t stopped innumerable foreign companies from doing well in China.  But to succeed, you can’t ignore the risks.  I is also worth mentioning that, as long as China continues its progress toward the free market, these kinds of risks will decrease over time.