China’s 48 trillion yuan (HK$60 trillion) stock market starts the week at a critical juncture with investors far from clear on the direction that Beijing’s recent policy pronouncements are supposed to be pointing them towards. A market stability fund with barely enough capital to cover an hour’s worth of trade, a raft of administrative curbs on share sales and police raids on futures traders whose hedging tools are cornerstones of standard capital market risk controls are among the signs to many that Beijing is scrambling to understand the scale of the crisis it potentially faces and is trying anything it can to put a stop to it. “Beijing has lost control of the markets after numerous mistakes trying to stabilise them,” Paul Markowski of MES/Falconridge Advisers Inc, told the South China Morning Post. “The country’s latest moves to boost the stock market by loosening risk rules, allowing individuals to mortgage their houses to buy stocks and ordering banks to roll over margin debts is a sign of a policy paradigm gone haywire,” said New York-based Markowski, a long-time external adviser to the country’s financial and monetary authorities. With the equivalent of around US$3.2 trillion of value wiped out since the market peaked on June 12 in a trajectory that tracks incredibly closely three of the worst stock panics of all time – the 1929 Wall Street crash, Black Monday in 1987 and the bursting of the Nasdaq bubble in 2000 – the government’s uncertain response might be understandable. “If the US struggled to contain the fallout then, we can hardly point the finger at the Chinese authorities for having the same problem,” Simon Derrick, chief markets strategist at BNY Mellon in London, told the Post. For many market participants it is precisely that risk of the unknown that makes Beijing’s policy missteps all the more telling. “Really this is the first time in recent memory that the Chinese government appears to be losing control,” said David Cui, China equity strategist at Bank of America/Merrill Lynch in Singapore. Cui likens the situation in mainland equity markets to that of the 2007 subprime crisis in the US – the trigger point for a global market meltdown, the fallout from which the world’s financial authorities are still grappling with. “It wasn’t necessarily the write-off that the market could not bear, it was – at that time – that people did not know where the risks were and people stopped buying, particularly in the bond market, which essentially triggered a bank run in the shadow banking market globally,” Cui said. The received wisdom is that the mainland’s relatively closed capital account and financial markets will keep contagion risks contained within the country and thus enable Beijing via the People’s Bank of China (PBOC) and other systemically important institutions to resolve the situation. The problem is that a run on the shadow banking system just inside China could effectively cut off credit across the economy. As shadow banking essentially encompasses the entirety of the PBOC’s measure of “total social financing”, that’s a 164 trillion yuan problem to contain, according to analysis conducted earlier this year by experts at the Brookings Institution. Numbers on that scale tend to support Cui’s view that contingent risks in China are most likely higher than they were during the subprime crisis, but that nobody truly has a handle on exactly how big the problem is. All of which is an additional worry to investors used to believing that – the opacity of the system to outsiders notwithstanding – Beijing has a grand plan and is continually recalibrating policy settings to ensure that its agenda, economically and politically, is achieved. Instead, what appears to be emerging from four weeks of the worst market turmoil in eight years, is the view articulated by CLSA’s closely watched markets strategist Christopher Wood, that the mainland authorities have “suffered a rare ‘own goal’ in terms of economic policy”. For Wood, the benefit of hindsight is that Beijing sowed the seeds of this market collapse last year when it telegraphed that initial public offerings (IPO) for A shares would be restarted after a long-running suspension, ahead of reforming the IPO process to bring it more into line with international market practice. With pent-up demand for new listings running red hot in a market where IPOs – given the way the rules allow them to be priced and traded – had almost universally delivered a massive 44 per cent gain on their trading debut in the months running up to the crisis, the government had effectively put stock buyers onto a sure thing. As IPOs suck liquidity out of the secondary market, it exacerbates the margin finance problem if already listed shares fail to continue to rally. Falling stocks paid for with borrowed money force investors to sell more to pay back the debts owed. This vicious cycle was in full flight when benchmark stock indices in Shanghai and Shenzhen peaked. Official margin finance was some 2.3 trillion yuan on June 18, with analysts estimating that unofficial lending took the total above 5 trillion yuan, or around 20 per cent of the freely available stock trading on the country’s two key exchanges. With around 1.4 trillion yuan of that official margin finance still left to unwind three weeks past the peak, a significant cloud remains hanging over mainland equities. While understanding that process might help explain the scale of the falls of recent weeks, the massive run-up in volatility that has accompanied it will doubtless be ringing through the corridors of power of a government obsessed with stability. Creating a fully functioning market mechanism and giving a greater role to markets in allocating financial and other resources has been a key policy objective of President Xi Jinping since he came to power. Pro-reformers had pushed the market agenda on the basis that it was the best way to tackle the mis-allocation of capital that is dragging on economic growth and to help give mainland firms the best chance of succeeding on the global stage, transforming them from low-cost assemblers to high value-added originators to build national prosperity – the key ingredients for delivering the economic and social stability that the Communist Party says legitimise its one-party rule. Funds are badly misallocated – going to firms when they shouldn’t, going to property when they shouldn’t, and going to stocks when they shouldn’t. Making the problem considerably worse is excessive liquidity Derek Scissors, resident scholar, American Enterprise Institute The last four weeks will clearly have hit home just how little control of markets governments really have, especially those in the early stages of development where reform is running faster in some areas than others, where regulatory responsibilities overlap and where the system is ill-equipped to understand and respond to the problems faced. If anything, this market meltdown shows just how far Beijing remains from building a market-oriented economy. “China isn’t even close to a commercial financial system, where risk and returns are tightly linked,” said Derek Scissors, resident scholar at the American Enterprise Institute who specialises in Asian economic issues and is responsible for compiling the most comprehensive private sector database of China’s outbound investment flows. “Funds are badly misallocated – going to firms when they shouldn’t, going to property when they shouldn’t, and going to stocks when they shouldn’t. Making the problem considerably worse is excessive liquidity: the money supply stood at over US$20 trillion in the first quarter, compared to US money stock of just under US$12 trillion. So capital is not just misallocated, it’s misallocated in enormous amounts. The result is that the boom-bust cycle China has had for 30 years has gotten worse,” Scissors told the Post . “The financial reform challenge is therefore absolutely enormous. Not only must China build a commercial system, it must do so without being able to ease the pain of reform – the pain Premier Li Keqiang talks about – with loose money. The benefits from loosening were exhausted in the 2009-10 credit boom. Now all loosening does is make the next bubble bigger and the next pop louder.”
