Advancing sustainable growth in the United States and China

Voices: Why China’s Stock Market Crash Matters

By Houze Song

Pensioners and punters are hurt by the market drop—and the overall economy may suffer, too

The direct impact of China’s recent stock plunge on the world will be rather limited, since domestic investors own the majority of China’s A shares. But the indirect impact will be much bigger. The recent stock market turbulence will have a sizeable impact on China’s growth, leading to less imports and lower growth in countries exporting to China. In addition, since China has been contributing about a third of world growth, a further slowdown in China would also have a significant effect on the global economic outlook and market sentiment.

Some people like to cite the fact that China’s 2007 stock crash had relatively little impact on economic growth as evidence that the stock market doesn’t matter much in China. But this time is different. 2007 was a period of economic overheating, whereas now China is near deflation. A tumbling stock market under the current macro environment is likely to have a much more severe effect on the economy.

The stock market affects China’s real economy largely in two ways. First, the valuation of the stock market affects the health of firms’ balance sheets. A booming stock market helps companies both to raise new capital and to reduce their leverage. This is especially important, since China is undergoing a deleveraging process. The availability of new equity capital makes deleveraging less painful for both firms and the overall economy. This benefit is not limited only to publicly traded firms: companies that are seen either as potential M&A targets or IPO candidates also gain from this boost in valuation. Higher stock values should at the very least lower companies’ cost of capital.

Second, a bull market also encourages investment, since it offers investors lucrative returns and the ability to exit easily. In the long run, China’s high investment rates will fall from its current high levels as the country’s economy becomes more mature. The conventional wisdom is that there is too much investment in China—and that the economy needs more consumption-driven growth. But actually, since China’s GDP per capita is less than one-sixth of US’s, there are still abundant investment opportunities. The problem is not investment per se, but the fact that most investment in China is not driven by markets, but instead by the government. In the meantime, China’s stock market is channeling capital to the right sectors. The firms that enjoy the highest valuations are in high-tech, health care, and e-commerce, not less efficient traditional heavy industries. Since investment accounts for half of GDP growth in China, robust investment growth would help smooth China’s ongoing economic transition.

Another reason the stock market is important to the overall economy is that the traditional bank-dominated financing model is running out of steam. The latest survey of banks by the People’s Bank of China shows that bankers’ forecast of future loan demand is at the lowest level since 2010—in part because of the economic slowdown, and in part because banks generally have a hard time finding smart investment opportunities. This means there is a serious disconnect: in China, the number of new startups—and the inherent need for investment to nurture their success—is at record high. This again points to the dire need for more equity financing, to help ensure the success of China’s economic transition to a more consumption-led model. Of course, a booming stock market also creates distortion and waste. But those negatives should be weighed against the weakening economy. It’s true that though the stock market has been white hot, China is still on the verge of deflation. But that doesn’t necessarily mean that the booming stock market has not helped the real economy. We don’t know what the economy would look like if there hadn’t been a bull market. Here’s an educated guess: the economy would probably be in much worse shape, as neither consumption nor investment would have been be as high.


Houze Song

Research Fellow, Paulson Institute

Houze Song is a Research Fellow at the Paulson Institute, where he does economic research and editing for the Think Tank. A Columbia University-trained economist, Song previously worked as a researcher at Columbia Global Center (East Asia). Before that, he worked as a research manager at Unirule Institute, where he assisted the preeminent economist, Mao Yushi, with research and project management. Song holds an MA in Quantitative Methods and a MPA in International Economics, both from Columbia University.

Topics: Economy