Monday, July 13, 2015

Greece is a Mess - but China is the Real Worry

By Roy C. Smith

Three trillion dollars. That’s the amount wiped off the value of shares in China over the last three weeks. That’s about ten times the GDP of Greece.  The government is forcing a rescue of the plunging market, but will it hold? An avalanche in China would be far more consequential than Greece leaving the euro.

There are big differences between the strategies employed in Athens and Beijing as they wrestle with their problems.

Greece is trying a “tyranny of the weak” strategy: if you won’t give us better terms, we will die on your doorstep. It is unlikely to work in the long run. Despite its referendum, Greece is broke, and will have to restructure.  How it does so, and over what time period, is really a European political issue that will go on long past the present deadline.

China, on the other hand is pursuing a “tyranny of the strong” approach: we are powerful enough to be able to make things the way we want them. However it has no more likelihood of success than the Greek strategy.  Applying government resources to manage markets (sorry, that should be to “uphold market stability”) is hugely expensive, creates a lot of other problems, and cannot be sustained for long periods.

Over the past year or so, China has used its authoritarian powers to stimulate financial markets to reverse declining growth through a combination of liquidity measures and policy changes aimed at increasing credit availability and stock market investment.

Lots of money has been poured into shoring up weak local and municipal governments and state owned enterprises, and to increase margin credit for stock purchases.  Clearly, there has been an orchestrated effort by the Xi Jinping government to manage markets for political purposes, which have included creating a bull market to encourage confidence in further economic growth.  

But the bull market became a bubble, and the bubble began to burst into free-fall, requiring further intervention to shore it up.

Over the past three weeks these efforts have become extreme. Among them are are halting trading in half of all listed shares, suspension of IPOs, halting short-selling, directing its sovereign wealth fund and public pension funds to increase stock purchases, and creating a Market Stabilization Fund by 21 “willing” brokers who have agreed to invest additional $20 billion in stocks, and not to sell any stocks while the Shanghai market index is below 4,500 (after a recovery in the last two days, it’s currently at 3,877). $20 billion may be only 0.16% of the $12 trillion market capitalization of the various Chinese markets, but it surely is a lot to the 21 brokers who have agreed to provide it.

Will the government’s effort be able to stop the rout?

Certainly, they might. China has vast resources that could be applied. So far, however, the government seems to be relying on its power to tell people what to do rather than on its deep pockets.  

Japan, which suffered a similar market crash in early 1990, also intervened extensively (to the extent of about 0.8% of market capitalization) to halt the decline, which, like China’s, reached 38% after the first few months. It worked for a while, but not for long. Two years later, the Japanese market index had dropped 65% from its pre-crash peak.

Once the Chinese government decides it has stabilized the stock market sufficiently, and withdraws the extraordinary measures, it is likely that the market will find very little support. 

Eighty percent of Chinese stocks are owned by the country’s 400 million urban middle-class. These investors, who have trusted the government’s economic policies, have already lost a lot of money and many have suffered calls on margin loans that, in response to stimulus efforts, now amount to about $1 trillion.  

Some of the suppliers of margin credit, such as smaller banks, financial intermediaries and government agencies (e.g., China Securities Finance, which was told to increase margin lending to stop the decline) will be endangered, and may been to be bailed out in order to prevent further panic in the markets.

Loans made to shore up weak credits will increase China’s abundant supply of non-performing loans, causing either bankruptcies or further intervention by the government to paper them over

What confidence China has earned from the world and its own prospering middle class in gradually adopting market economics will be lost, and what transparency there has been will be sacrificed as cover-ups spread throughout the system. Most important, a loss of confidence in the Chinese economic miracle would greatly imperil the government’s paramount objective of reversing a declining GDP growth trend.

Because China isn’t a democracy, President Xi has more power than the other leaders. He can make bigger bets that he can override market forces. But, even in China there are factions and rivals that raise the stakes for President Xi to avoid an economic meltdown.

The urgency of addressing the stock market decline has pushed proper, long overdue economic reform into the background. A portion of a World Bank report earlier in July urged China to accelerate reform of its state-dominated financial sector. "Wasteful investment, overindebtedness, and a weakly regulated shadow-banking system," had to be addressed for China's broader reform agenda to succeed, it said. The report also warned that failure to address these issues could end "three decades of stellar performance" for the world's second-largest economy.

China’s response was to request that the offending portion of the report be withdrawn, which it was.  Indeed, since then, rather than thinking about ways of reducing state intervention it has ramped it up. Reforms, if the words can ever be applied to a system so dependent on government intervention, will have to wait until fears of the China bubble bursting are over.

In many areas of policy Beijing’s ‘tyranny of the strong’ mindset works. And in this area too, it may appear to work for a while.  Markets can be propped up, with effort, for months or even a year. But then there is a moment when the markets want no more of it, and start to collapse. Despite efforts to counter it, the collapse gathers steam and can end up as an avalanche.

from eFinancial News, July 9, 2015

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