August 3, 2015 7:00 pm JST
Sean Miner and Jan Zilinsky

Falling stock prices do not always presage a bad economy

Are falling stock prices in China a sign of deeper economic frictions? Is a drag on the real economy inevitable? As Nobel Prize laureate Paul Samuelson said, "The stock market has predicted nine out of the last five recessions." The economist was reminding us that observers who are guided by share price movements alone will be spooked about the state of the economy more often than warranted.

    Traditionally, the growth of Chinese stock prices has only weakly correlated with the growth of the overall economy. China's stock market over the past two decades has risen significantly only once, in 2007, and subsequently fell, while GDP growth during this time has typically hovered between 7% and 12%. 

     According to our calculations, the link between recent stock price movements and GDP growth in China is positive but small. One well-known study has found that the statistical association between past stock returns and contemporaneous economic growth is so small that in half of the emerging markets with available data it is indistinguishable from zero.

     Based on our calculations from the historical data for China, a simple prediction would be that a 30 percentage point fall in stock prices would shave 1.14 percentage point off growth. Past experience is not a perfect guide for the future, but overstating the link between the financial market and the real economy is easy, especially while stocks are volatile.

     Why should we expect that lower stock prices might hurt economic growth in the first place? A key concern is that aggregate demand could fall because of the weakening of household balance sheets. Consumption is typically determined not only by current income but also by the total value of consumers' assets. One way to trace a possible connection between the stock market and the real economy is to examine the proportion of assets that households allocate to equities.

     At the end of 2014, Chinese households held, on average, 10% of their assets in stocks, and out of 350 million households, a maximum of 30 million to 35 million had exposure to the stock market. Household consumption was around 37% of China's GDP, and the exposure of Chinese households to equities is, on average, still limited. Therefore, even a 30% drop from recent stock market highs will have little effect on household wealth, as the majority of household assets are in cash or property. In addition, while China's market capitalization as a share of GDP reached 120% during the 2007 stock market boom, the recent surge did not see market capitalization even reach 100% of GDP, indicating that the stock market may be having less influence on the economy this summer. 

    That said, this view is limited. An important point is the distribution of households with stocks. Millions of broker accounts were opened in the past year with under 10,000 yuan ($1,610), indicating that a substantial number of low income households hold stocks. A sharp downturn would have a greater effect on these households than on those with higher incomes. 

     In addition, sudden asset price reversals can lead households to adjust down their expectations of future income and wealth. Depending on the magnitude of this sentiment, households could choose to stash more in their bank accounts instead of spending or investing.

     Finally, the financial sector, strengthened by increased trading activities in the first half of this year, contributed to GDP growth by more than 20%, double its normal contribution. This is likely to come down in the second half of this year and thus could have a small effect on GDP. 

     The crash, then is seen having limited economic impact. Its political ramifications are also expected to be limited. Will retail investors expect the Chinese government to rescue the market next time there is a steep drop? They shouldn't: The government will not be eager to repeat the initiatives taken to arrest this slide. And if China wants to gain the confidence of foreign institutional investors, it will have to show over the next couple of years that it has the resolve to let market forces determine the stock market's path. One acceptable exception to a noninterference policy would be countercyclical measures to slow any sharp rise, similar to past measures to cool off the steaming property market, to prevent another unstable situation.  

     Sean Miner is China program manager and research associate at the Peterson Institute for International Economics, which he has been associated with since June 2013. Jan Zilinsky has been a research analyst at the institute since October 2014.

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