The significance of the Chinese stock market crash

August 7, 2015

In the previous post I looked at the big picture of the Chinese economy, examining the big structural imbalances that will need to be addressed though a major economic adjustment over the new few years and possibly decades. For a variety of reasons, such as the scale of the structural problems, the depth of the imbalances, the power of the parts of Chinese elite who are heavily invested in the old unbalanced model and who will try to block change, it is likely that the coming adjustments are likely to be difficult.

Recently the Chinese stock market crashed. Beijing responded with what looks like being the largest financial bail out in history. How does this fit in to the big picture and what is going on?

The Chinese bull market (a period when share prices consistently rise) started in December 2012. The state media was a cheerleader during the market’s bull run, reinforcing impressions that the government was supporting the rally. An April commentary in the People’s Daily, the Communist party’s flagship newspaper, is now infamous in China for declaring that “4,000 [points on the Shanghai Composite index] was just the beginning”.

Brokerages and fund companies were complicit in the propaganda effort, encouraging the perception that government policies would drive the market higher. Investment storylines talked about “concept stocks” linked to big themes such as state-owned enterprise reform and Xi Jinping’s “New Silk Road” infrastructure blueprint for Asia and Europe.

The same month that the People’s Daily commentary ran, a Shanghai bank branch placed a blackboard outside its premises. Chalked on it was a message urging passers-by to: “Keep in step with policy and seize market trends! Selling red hot: SOE [State Owned Enterprise] reform, New Silk Road, the most bullish concept stocks!”

The government’s creation of the Chinese bull market has disproportionately benefitted state-owned companies, and therefore the Communist Party, by replacing government-guaranteed debt with equity. As explained in the previous post on China the large state owned enterprise (SOE) sector in China receives most of the very cheap investment funding and credit facilities of the official state owned banking system, leaving the private sector heavily dependent on the far less regulated and much costlier unofficial shadow banking system. This preferential funding of SOEs is not based on economic performance, SOEs are favoured for political reasons and because the personal wealth and power of a significant section of the Chinese ruling elite is built upon the large SOEs. The result of the state banking system pumping so much money into the inefficient SOE sector has been an escalating non-performing loan crisis inside the Chinese banking system. The SOEs are dependent on a high and perpetual inflow of essentially free money in order to function and switching funding from bank sourced loans to capitalisation via equities and share offerings was seen as a way of ‘reforming’ the problematic SOE finances. Alarmingly SOEs were encouraged to use the soaring value of their shares as collateral to raise further loans.

Underneath the problems of the SOE and the banking system sits the far bigger and deeper problem which is that the high growth strategy based upon low consumption and very high investment in mega projects and property development is rapidly running out of steam. As the previous post explained China has to fundamentally reorientate its economy away from high savings and high investments and drastically increase the proportion of GDP going to personal consumption. That is going to be a very difficult transition.

A lot of small scale savers and investors have invested in the soaring equity in the bull market. When the state press and government officials began pumping stocks about a year ago, they essentially made a promise to protect the savings of tens of millions of households and now those savers have seen the value of their savings collapsing along with the stock market. The issue of personal savings is a big part of the rebalancing that needs to happen. Chinese consumers need to save less and buy more in order to help rebalance the economy but years of financial repression (the state dictated forcing down of interest paid on savings in order to generate cheap capital for the SOEs and the investment program) meant that Chinese households saved a large proportion of their income. At a personal level this is prudent and necessary in a country where for many there is now essentially no system of social security, pensions or socialised medicine. The bull market seemed to offer household savers a way to earn more from their savings which might over time allow them to reduce the levels of their savings and thus help rebalance the economy. Now a stock market crash is wiping out those savings which will push down personal consumption and thus actually deepen the structural imbalances in the Chinese economy.

Although the stock market in itself does not drive the economy the recent state sponsored bull market, the surge of small investors and the encouragement given to SOEs to use rising equity value as collateral to take the pressure off the state banking system are all intimately connected to the fundamental structural imbalances in the Chinese economy. This is why the Chinese government has stepped in with a gigantic bail out package designed to stop the fall in share prices, prevent wider contagion in China’s brittle financial systems and stop millions of small investors losing their saving, something which could pose unknown political risks.

So, how much money has Beijing actually spent trying to support the markets? Economist and Peking University professor Christopher Balding has tallied it all up, and arrived at an astounding figure—$1.3 trillion.

That’s more than five times the $247 billion the US government initially spent on the Troubled Asset Relief Program, or TARP, that was used to support financial institutions after the 2008 financial crisis. Here’s how Balding got to that figure:

June 29: China’s pension funds are allowed to invest in stocks for the first time—$100 billion.

July 3: The People’s Bank of China (PBOC) makes new loans to banks—$40.2 billion.

July 4: China’s major securities brokers pledge to invest to stabilize the market—$19.3 billion.

July 8: China Securities Finance Corp. (CSF), which makes margin loans for stock-buying, pledges new liquidity to mutual funds—$32 billion.

July 9: The PBOC pledges new financial support to CSF—$41.9 billion.

July 14: Beijing extends a program that converts local government debt into bonds—$450 billion.

July: Additional provincial bond support (sources tell Balding, no official confirmation)—$161 billion.

July 17: CSF given $483 billion in additional funds from the PBOC and state-run banks.

The figure doesn’t include other stimulus measures that were rolled out before the June plummet but are surely adding liquidity now. Among them: a series of reserve ratio cuts since December that added $282 billion in liquidity, and the PBOC’s $62 billion capital injection into two state banks in April.

If they were included the tally of total support would be an gigantic $1.6 trillion.

That is far and away the largest economic support package in history, and reflects the fact that government is dealing with some profound problems probably related to a much larger bad debt problem in the banking system than has previously been officially acknowledged. There is growing concern about the liquidity of China’s commercial banks.

The Chinese Communist Party Third Plenum of the 18th Central Committee in November 2013 initiated a reform program intended to begin to address some of China’s deep structural imbalances and although some important reforms were pushed through it was essentially timid about addressing the core fundamentals that need changing. The reform package was portrayed as starting a reform of the state owned enterprises (SEOs) but at the same time the Third Plenum reaffirmed the dominant role of the public sector in the economy, although the market was upgraded to a “decisive” role in allocating resources, in contrast to the previous characterisation of the market’s role as “basic.”

“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

The quote above is the most celebrated of Xi’s statement about the much hyped Third Plenum policy reforms, and was interpreted as meaning that it would now be markets and not government policy that would determine the value of money and risk in the Chinese economic and financial system.

Financial sector liberalisation was a central focus of the reform package with measures to allow for private capital to set up small and medium sized banks, calls for the establishment of a deposit insurance system, and the acceleration of market-based interest rates and the convertibility of the renminbi capital account.

The reform program also began to address the the mighty vested interests in the state-owned enterprises (SOEs) with announcements that thirty percent of SOE profits would be remitted to the central government by 2020, up from the current zero-to-fifteen percent. Private firms also will be allowed to enter some of the protected sectors, such as railway, and they were to be encouraged to take part in reforming the state owned enterprises. The Third Plenum program also called for professionalising the management of the SOEs and for separating their business functions from government.

The problem now is that by its massive intervention to artificially prevent a significant stock market adjustment it is signalling that in reality the government deems an enormous swath of China’s economy such as the property market, state-owned companies, financial products, and now the stock market as being ‘Too Big to Fail’. That’s a government program that going to become very expensive indeed and may well be futile. China has already racked up at least $28 trillion in debt, more than half of which is corporate, a massive government bail out programs will merely add to that debt mountain.

Politically, when the government decided to create the stock rally, Xi and the Communist Party put their credibility on the line with more people than ever before. Past policy decisions might outrage a region, or an interest group, but usually not millions of households across China.

Financially, hundreds of billions of borrowed yuan have flowed into equities. If that wealth is lost, those debts can’t be repaid, which is why the government rigged Chinese stock rally may have left the whole financial system at risk. Coming on top of years of bad lending to SOEs and mega investments which has left the banking system stuffed with non performing loans the stock market crash is further sapping the liquidity of the commercial banks. A crises in banking liquidity would undermine the funding going forward for the national investment program which is the key driver of Chinese growth. With personal consumption barely growing (and now probably taking a knock from small investor stock market losses) a slow down in the investment program could cause the whole economy to stumble.

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