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China's Market Meltdown: Part II

Still in a bit of a funk after Monday’s 8.5% decline in the Shanghai Composite Index, investors continued to exit Chinese stocks Tuesday, pushing the Index down another 1.68%.

As we observed last time, the current downdraft in China is more reminiscent of our 1929 Crash than either our 1987 or Dotcom (2000-2002) crashes because this one, like our ’29 lollapalooza, came after a margin credit-fueled mania in an economy that itself was overleveraged. If this rout turns out to be of the credit-related variety — like our 2007 housing debt-caused Crash — then what might be expected as a result over the next several months?

Let’s look at some possible outcomes if 2015 turns out to be Shanghai’s 1929 or 2007.

China Suffers a Recession

A market crash doesn’t automatically lead to a recession (as the experience of 1987 demonstrated), but credit-fueled stock manias that end in a crash often do because when credit contracts and the banking system start coming undone, the entire economy suffers.

In this country, the Crashes of 1929 and 2007 sparked massive government intervention to keep banks afloat and to re-grease the wheels of credit creation. In China, the government already manages the economy and the banking system so thoroughly and so opaquely that they’ll probably do everything they can in the way of propping up banks and creating liquidity to keep the system going.

But reality eventually bites, even in Communist countries. The elimination of so much leveraged stock market wealth may affect the spending plans of millions of Chinese, pushing the country into recession.

Political Unrest

The social deal for many years in China has been that the population tolerates the Communist government and a lack of political freedom in exchange for a steadily rising standard of living. What happens if living standards and income decline? Will the Chinese people still buy the deal?

The Communist regime won’t give up its power easily, but millions of Chinese have moved into the middle class and have seen Western-style freedoms in person or through the media. That taste of how other modern people live may translate into demands for greater transparency and a more representative government. Think of what the Tiananmen Square protests would have been like if there had been an Internet in 1989.

Spreading Slowdown

If a slumping stock market leads to a further slowdown in the Chinese economy, the chilling effects will be felt worldwide. Some Asian countries are complaining that China is dumping goods to retain market share. Commodity prices are lower because demand from China has slowed.

Ruchir Sharma, Head of Emerging Markets at Morgan Stanley Investment Management, told Bloomberg News that a continuation of China’s slowdown may drag the world into recession since the country is the world’s second-largest economy.

“Over the next couple of years, China is likely to be the biggest source of vulnerability for the global economy,” he said.

Another Possibility: A New Casino

One point not to be forgotten in all this conjecture is that the Chinese stock market for international investors is in Hong Kong; the Shanghai market is more like Aqueduct or Hialeah for Chinese speculators who like to gamble. If these Chinese investors merely shrug their shoulders over their losses and go on living as if nothing happened, the Shanghai crash will be more like 1987 than 1929. And the floating Chinese speculative crap game — which moved from real estate to the stock market — could very well pick up stakes and alight on some other “investment.”

Let’s hope that’s the worst that happens.