Reflections on China’s Stock Market Bubble

“We must deepen economic system reform by centering on the decisive role of the market in allocating resources….” —  President Xi Jinping, “The Decision” of the Third Plenum, Nov. 2013

“What people don’t realize is that China papered over its last two credit bubbles, those in 1999 and 2004. The banks were never bailed out – they just exchanged their bad loans for questionable bonds from quasi-state organizations.”  — James Chanos of Kynikos Associates

Last Monday – the 27th of July, was a disaster for the Shanghai stock market. The greatest one day decline in 8 years wiped out 8.5% of market capitalization. The plunge rang the curtains down on a six day rally – one that was clearly engineered by the government to arrest a freefall starting late June, wiping out some US$4 trillion or almost a third of the value of the A-shares market in three weeks.  Amidst all the panic, what is conclusive is that neither the incredible bull run nor the dramatic fall in prices reflects the underlying performance of listed companies.

China SCI

Desperate times call for desperate measures and when in China one need look no further than the arms of the state for succour. Beijing intervened with a suite of measures that included a ban on short selling, ban on major shareholders sales and on new listings, massive coordinated buying by large state controlled institutions dubbed “the national team” and significant direct credit support from the central bank. While the selloff was at its peak in early July, trading was suspended on more than half the listed companies and to this day almost 20% of counters are barred. Michael Pettis, who in my view offers the most credible narratives on China and its economic affairs, called it an act of “brute force”. Economist and Peking University professor Christopher Balding has tallied up the stimulus and support measures and he pegs it at an astounding $1.8 trillion. Here’s a recent piece from Caixin online that goes into the details of how Beijing intervened over the July 4-5 weekend. One in particular stood out for me.

“ After the sit down (with the capital markets regulator of course), the firms (21 securities firms) announced in a joint statement that to stabilize the stock market they would spend at least 120 billion Yuan combined to buy exchange traded funds linked to blue chip stocks listed on the Shanghai and Shenzhen bourses. Moreover, the firms pledged to hold all the stock that had been bought with their own money until the index reached at least 4500 points

The China State Regulatory Commission ordered the firms to handover that 120 billion Yuan to the China State Finance Corp (CSF), a four year old agency co-founded by the country’s major securities and commodities exchanges and clearing house to finance brokerage firm’s margin trading and short selling business. ”

The sheer ambition behind the effort is apparent in that here we have the state willing to prop up and rescue an index.  Recent economic history begs a comparable. Holy cow!  It even beats past episodes where central banks and the state mounted dramatic rescues of individual banks and operating companies grappling with liquidity crises. Finally markets did breathe a sigh of relief – the Shanghai market rallied by 20% over the period from July 9th to the 23rd. And crisis vocabulary added a new term – after Greenspan and Mario Draghi we now have the “Xi Jinping put” as Joyce Poon of Gavekal Dragonomics calls it. This being a reference to the act of government assuring investors that it will do all it takes to keep the market aloft.

But intervention creates its own volatility and as it stands today, the fate of stocks rests no longer on the bedrock of value but rather with state officials. Not surprising then that it only took rumours that the CSF had started to sell its stock positions to send panic signals that caused the fall of 27th July. I therefore believe that authorities face a catch 22 situation. They’ve intervened with brute force to avoid a fall. But they’ve locked themselves in because should they wish to exit, they’ll precipitate a decline that will almost surely dwarf the one they tried to avoid.

Taking the ‘free’ out of free markets

China’s rigged markets will surely disappoint foreign institutional investors. Why would institutional investors take positions when the government can control if and when they can sell. Bridgewater Associates LP, the world’s largest hedge fund and an outspoken bull on China caused a flutter or two by reversing their long held views in a 10 page letter to clients. Here’s Bridgewater’s Ray Dalio on government intervention in equity markets. By the way, the letter commenced with the quote “Our views on China have changed as a result of recent developments in the stock market”

“History has shown that smart investors tend to sell when the government is artificially supporting prices and buy when they are liquidating positions. One other consideration is that large stock interventions by governments tend to discourage institutional investor’s participation because they consider that to be price manipulation that makes investing more confusing and less economically based.”

Wall Street can continue its tirade but I’m inclined to believe that Beijing will intervene to stabilize markets despite knowing that they’re in bubble territory. The question is – why does Beijing feel compelled to do so while there is a risk that in suppressing volatility they are setting the stage for a more disruptive adjustment in the future? In my opinion, answers lie in figuring out how equity markets are entwined with China’s intent to rebalance the economy and transition from investment driven to domestic consumption led.

The Chinese rebalancing conundrum

The Chinese government’s economic reform and rebalancing program hinges on creating a domestic consumer base that can maintain high aggregate demand. It is perceived rightly so that rebalancing will serve as ballast to the economy from external demand shocks. But to arrive there, household incomes need a boost and more Chinese need to spend than save their disposable incomes. The latter is more likely to happen when a sense of financial security is instilled in the populace. Unfortunately, these are also two areas where policy has struggled to make headway. To understand why that is so, we need to take a step back in time and understand the growth model that has dominated public policy in China to date.

The traditional growth model was grounded on low cost exports and massive investments in infrastructure by state led enterprises. The former necessitated keeping manufacturing wages low in order to preserve export competitiveness. The latter was funded by artificially repressing interest rates on savings deposits.  I’ve heard quite many experts wrongly opine that Chinese investment in infrastructure and construction has been made possible by thrifty households. Indeed, not too long back I might have fallen prey to similar thoughts. In reality, Chinese GDP grew much faster than wages over two decades until 2011-12 and this resulted in the Chinese household income share of GDP declining. Because most consumption is at the level of the household, consumption as a percentage of GDP also declined to an astonishingly low 36% in 2010. Now, since savings is what one gets after consumption is deducted from income, the obverse is also true i.e the savings/GDP statistic progressively increased.

Rebalancing to a consumption oriented economy came with constraints. China’s leaders could not in any way undermine the low cost export model or derail infrastructure investment driven growth. This meant that the public would have to be presented investment avenues to earn positive real returns on their savings but those options could not direct capital away from domestic manufacturing and construction sectors. Removal of capital controls would have allowed savings to flow overseas and so was not an option. Moreover, free flow of capital in and out of the country would shackle the state’s ability to control the RMB’s value. Back in the 90’s, real estate and stock markets were avenues that Beijing settled on to achieve ends.

However, in early years, stock markets were effectively sidelined  as Chinese preferred real estate to channel their savings. Indeed, the trend would continue for almost two decades as home sales and prices rose with unusual consistency. It is worth noting here that rising asset prices unleash a “wealth effect” which in turn through the behavioural channel can cause people to consume more. Needless to say, government support had a major role to play in propping up prices and volumes in the market. After the financial crisis of 2008-09 delivered a body blow to the low-cost export sector, government stimulus flowed into construction and boosted employment. Keeping interest rates low was embedded into monetary policy thereon. Back in 2010, the then Governor of the Bank of Japan had this to say in his speech

“Protracted low interest rates play an important role in preventing an economic downturn, but, at the same time, they tend to delay adjustment in excesses accumulated during the period of bubble expansion. In addition, they also tend to delay the rejuvenation of businesses.”

Monetary policy was in effect subsidizing state owned enterprises, real estate developers, infrastructure players, and local/municipal governments while taxing savers. Household consumption was given the short shrift. Deposit rate liberalization after all would’ve caused funding costs to rise.

Today, China’s housing markets have entered a period of protracted decline. Real estate no longer promises the returns it once did. The economy is also in slowdown mode – disinflation since early 2013 has muted the increase in sales prices, wages, and input costs. Incremental aggregate demand in the economy now requires a higher contribution from private household consumption and consumption driven industries. It is against this backdrop that the massive, government supported equity market rally of the past 12 months becomes clear. In all fairness, the stock market rally is a recent development. Until October of last year, the Shanghai Composite Index was in the 2500 range and quite many analysts considered equities to be undervalued. By March of this year the index had shot up beyond 5000, spurred by thinly traded small and mid cap stocks. Chinese regulators had allowed the bubble to build up by allowing retail investors – many of them novices, to engage in margin trading. With that kind of leverage, a stock market collapse would surely have impinged on private household consumption. Would there have been negative knock on effects on the political legitimacy of the Communist Party? I’m less clued into politics but analysts have reasons to believe so. This point alone should dispel any doubts on why the government will bring in every bazooka available to support the stock market despite knowing all the time that’s it’s a bubble.

Now, should stock markets indeed collapse, what instantaneous effect might that have on flow of savings? In my view, a rush to safety is pre-ordained. Safety in China would be the domain of bank deposits. How would that work for a change? On the positive side, the banking system would be flush with money. Pumping credit back into the economy would no longer be a problem. The bad news is that massive state backed credit pumping is bound to be clearly unproductive in China where domestic investment is more commonly associated with negative returns. China’s ghost towns and cities stand testimony to this. But what would happen if Beijing were to compel the banks to not activate stimulus measures and curb lending? Repressed interest rates have made China’s banks lend as much as they can to maximize profits. So the only realistic way to curb lending is to raise deposit rates and thereby remove this perverse incentive. While this is bound to benefit savers, the move is certain to hurt state owned enterprises who are already suffering falling profits and reeling under heavy debt burdens. I doubt if the political regime can survive a collapse of this variety and hence this route is certainly not in the reckoning.

There lies a vexing problem – Unless deposit interest rates are raised or capital controls lifted for Chinese citizens to invest overseas, there are very few channels where citizens can generate wealth. Real estate is in the throes of a slowdown. A stock market collapse will exacerbate financial insecurity and cause private household consumption to decline. The bottom line is that authorities have a vested interest in ensuring that the stock markets do not collapse.

China’s stock markets & the economy

Whereas a stock market panic always awakens the bears who will bring up their own views on what is wrong with the economy, it is worth noting that markets can point to economic malaise but they  could lead or lag. Whether the stock matter crash matters to the economy is a subject that is worth exploring. My own view is that equity markets in China have exhibited weak correlation with the economy. But indeed, the crisis will exert some pressure on economic growth. Again Michael Pettis offers the most compelling arguments in this piece.

“It is hard to argue that the stock rally had any significant positive economic impact, so some analysts argue that its collapse will not impact the economy either.

This may be true in a direct sense. But there are three important ways the stock market decline might matter. The first is direct. The combination of the rally and the crash may represent a significant shift in wealth from poorer Chinese to richer Chinese. This must cause total consumption to drop, although the amount will depend on the magnitude of the shift, of which we have no information.

Second, and indirectly, if the market crash causes perceptions of economic uncertainty to rise, households might respond by cutting back on consumption.

Third, and also indirectly, if the crash undermines Beijing’s credibility or confidence in its ability to manage the economy, it could undermine the financial sector, which relies very heavily on the high credibility Beijing enjoys. This is the least likely but most damaging potential impact.

Of course the longer it takes for Beijing to stabilize the market the more its credibility is likely to be undermined. In a worst case scenario Chinese households may blame their losses on their having invested in the stock market because of what is widely perceived as very active cheerleading by policymakers.“

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