Watching China Wobble

Watching the breathtaking collapse of the Chinese stock market over the past few weeks has been an eye-opening experience for many who have known nothing but upward success on the mainland.

Starting in mid-June, the value of A-shares -foreigners can only purchase B shares on the Shanghai and Shenzhen stock exchanges--tumbled by 35%. This serious correction created a number of turbulent trading days globally. It may be far from over.

The Chinese are learning the hard way that "what goes up does come down" and when a stock market bubble is pricked, a whole series of unintended consequences may emerge as a result..

Nearly two generations ago, when President Nixon visited the People's Republic for the first time, China was an impoverished agrarian society which was struggling to feed itself and back then it only had a population of fewer than 1 billion people. Mao plunged China into economic chaos twice, first with the Great Leap Forward in 1958 and during the mid-1960's when he ushered in The Cultural Revolution which petered out only after his death in 1976.

However the seminal figure of Deng Xiaoping re-emerged after a decade "on the outs" and began to restructure the Chinese economy with its modern underpinnings. Deng carefully outmaneuvered Mao's ideological heirs and the rest was history. The country puts its brakes on population growth (today at 1.35 billion) and began a long period of structural modernization.

By the eve of the Beijing Olympics in 2008, modern China would have seemed a strange and alien place to somebody like Mao, whose face still profiles the Tiananmen Square. China had the resources to weather the Panic of 2008 and The Great Recession that followed by investing in a series of massive public works and infrastructure projects. The economy held together while the global picture wobbled badly.

Now that the correction has taken place on the Shanghai and Shenzhen stock exchanges, how will it cascade over the rest of the Chinese economy? In the United States, the real damage from the economic collapse of 2008 took time to work itself through the meat of the economy. For example, the our unemployment rate began to jump in 2008 as job losses mounted but did not climax until the early months of 2010, nearly 18 months after the markets collapsed. The real question is how the economic shock will impact the Chinese economy as this correction plays out. This might be an acute reckoning.

The modern People's Republic of China, which saw itself as a manufacturing powerhouse to the rest of the world, is now hemorrhaging low skilled jobs to locales where the labor force is even cheaper, like Vietnam or other poorer Southern East Asian economies. Worse, a roughshod approach by policy makers in Beijing, who have poorly executed an attempt to devaluate the Yuan, seemed to underscore a realization that endless years of 7% growth rates would become a thing of the past.

We all know that the stock market is only a snapshot of the overall economy. However, this could be the first modern recession in modern China. The current generations of Chinese worker, both white and blue collar, have seen nothing but upward mobility. Wages have skyrocketed since modern reforms were enacted. The transformation must be eye-popping for an older generation who were old enough to remember the turbulent days under Mao, or worse, life under Chiang Kai-shek.

In the United States there is a political outlet for economic disappointment. They vote the bums out. In 1932 when FDR and the Democrats were swept into power, most of the Republicans at all levels of power were swept out along with Herbert Hoover. From that point, The New Deal was born. Voters punished Barack Obama in 2010 for not solving the problems of the Great Recession fast enough. Democrats, who had celebrated only 2 years earlier, found themselves in a very tough political spot.

Regardless of the policy choices that Chinese leaders must face, the average Chinese citizen will not be able to go to the polls. How they choose to voice their frustration and how Chinese policymakers react will be a very interesting dance over the next 18 months.

Things are far trickier in a one party state. You cannot blame the problems on the "Capitalist Roaders," the term Mao used demonize people like Deng and imprison his opponents. The "Capitalist Roaders" won that battle long ago. You cannot blame the "Other Guys" because Chang and the Nationalists fled to Taiwan in 1949 after losing the Civil War to Mao. Instead, Chinese authorities have arrested roughly 200 people; rumormongers about the stock market instability. They are being jailed for essentially what the people on CNBC do for a living on a daily basis. While some have been arrested on insider trader charges, those arrested for simply offering their explanation to why things have gone awry is troubling.

There has been an implicit social contract between the Communist policymakers in Beijing and the populace at large. The Beijing government would retain its total political control over every aspect of Chinese society. However in return, the average family would see a vast improvement of their overall lives.

Until now this has worked spectacularly. However, as discontent and worry piles up in the minds of the average Chinese worker, how will they respond? It remains the unanswered question. This is new territory for a generation who know nothing but success. The slowdown we are seeing appears to be far broader-based than originally thought. Elites in China are now learning the tough lesson that a market economy operated in cycles. What's more is that modern Chinese do not have the social safety net that we take for granted here in the United States.

Somewhere Mao is rolling over in his grave, which makes this all more ironic. The United States has gone through a series of its own ups and downs, most notably the panics and economic downturns that began in 1929 and 2008. The idea that Chinese central planners would be answerable to the larger market forces is something Mao or Zhou Enlai would have found revolting. Both were old fashion command economy politicians and they would have never given the concerns of London or New York bankers a second thought.

Back then, when the PRC was truly a Maoist operation, the West would only hear rumors about what was going from reporters who were based in then-British Hong Kong. The gamesmanship between Mao and his political opponents were left to open speculation. What made the 1972 Nixon trip to China so fascinating was that it was a first glance into what was considered a closed society.

More than 40 years later after that first visit, Chinese policy makers will have to come to terms with downsides of global integration because there are times when the markets correct. Overstating the growth rate sense from 7% to a more realistic 5.3% will come at a cost. The political choices made in Beijing earlier this year have come home to roost.

The road from here will amount to a brand new reality for all Chinese. How every sector of this economy reacts will speak volumes about how modern China will be perceived when it comes to economic leadership.