As I mention in my CNN interview from earlier today, this week’s market turmoil in China is likely only the beginning of a more significant correction. When the Chinese government acted so aggressively last summer to staunch the market crisis by forcing government-connected brokerages to buy shares and banning larger shareholders from selling for six months, they froze stock prices for many companies at prices unsupported by market fundamentals and perceptions of China’s prospects. Now, six months later, confidence in the overall Chinese economy has slipped, downward pressure on the Yuan is leading to capital flight, and panicked sellers, including Chinese retail in investors and institutional investors, are desperate to get out. The 7% circuit breaker – where the market would shut down after a 7% loss in a single day – was only making matters worse and was wisely dropped a few hours ago.
Beijing is beginning to realize the dangers of remaining in a limbo state with its economy party defined by SOEs and restrictive capital controls and partly by an increasing integration with the global economy. It really has no choice but to move in the direction of freer markets and economic reform, as its leaders have expressed a desire to do, but this will require meaningful political reforms to enable economic reforms and a very strong stomach. The legitimacy of the Chinese Communist Party and government is predicated on being credible stewards of the economy and delivering strong economic growth. A major crisis would challenge that, but that crisis could either come from maintaining too much control and stifling the economy or from letting go and letting the market dictate a painful correction. Either way, the seas are rough and, in the near term, will only get rougher.