Handling of Chinese stock market crash raises questions

Whoever might have lost out in the weird saga of the rise and fall of the Chinese stock market, there is one sure loser – confidence in China as a reliable free market player. And with that, it appears, the prospect of Renminbi becoming an accepted reserve currency by the International Monetary Fund has flown out of the window.

With China’s global trade rising and its kitty of unused foreign exchange reserves swelling to ever larger kitty, the country’s currency seemed to emerge as the newest reserve currency for global transactions. But then, the way the Chinese authorities intervened to bypass free market, the chances of its currency being accepted for multilateral transactions should look askance.

China was cheerleading its stock market as long as it was rising. It had used every instrument 

available to push it up, including, strangely, dangerous liberalisation of margin trading in stocks. It had used the central bank to loosen regulations for loans against shares or for buying equity. It had even encouraged ordinary investors to pawn their houses to get money for buying shares.

No wonder, that the equity market had sky-rocketed. It had gone up by 150 <g data-gr-id="105">per cent</g> in just one year. At the peak, China’s stock market was three times larger than India’s national income. Its stock market was much larger than most of the EU countries. But all the same it was a fake market, propped up by fake funding. That was demonstrated by the crash.

When the Chinese stock market crashed it had wiped out values to the tune of $3.9 trillion in just three weeks. That showed how fragile was the market and values rather flimsy. At the slightest touch of volatility, the market had tumbled and all those who had put their fortunes with borrowed money tried to save whatever remained of that.

But then came the worst. China allowed trading to be suspended. This is sacrilegious for any market regulator. It has now banned trading in over 1400 companies’ shares which <g data-gr-id="103">has</g> reportedly immobilised half of the Chinese stock market. Prices have surged thereafter on Thursday, but what value is that if half the market is kept out of trading. This begets many questions.

What will happen when the market eventually <g data-gr-id="98">reopens.</g> Will the value of the suspended equity rise or fall on de-freezing. Who can keep his faith in a market which does not allow liquidating stocks when prices are <g data-gr-id="97">falling.</g> You hold the investor to ransom and do not allow him to regain his money, however much, even at a loss. This is surely not a free market.

One might argue that circuit breakers work in other stock exchanges to cool down fluctuations. But that is an accepted market practice known to investors well in advance. This is not activation of automatic circuit breakers, this is imposition of trading ban because prices are falling.

The Chinese aspirations for making their currency a global instrument has to be seen against this background. What happens if the renminbi suffers against other major currencies like Dollar, Euro, or the yen in trading. Will the Chinese authorities allow the currency free float when it hits high fluctuations? In such cases, will the Chinese suddenly impose restrictions on trading in <g data-gr-id="107">Renminbis</g>. What will happen to those who might be holding large renminbi balances?

It will be important to consider these aspects now before the proposal for making the Chinese currency one of the SDR reserve basket. The proposal has been mooted by the Chinese and the IMF appeared to be disposed to considering it. Some serious discussions had already been set for examining the issue at the IMF. Surely IMF would now set some stiff stress tests for the Chinese currency.

China had professedly been working to create a free market economy. Some of the straps of state control had already been cut. Interest rates have, to an extent, freed up. But then, this crisis has shown that the <g data-gr-id="89">mid set</g> of statism had hardly left. <g data-gr-id="90">Heavy handed</g> government intervention is still a reality in China. Along with that the suspicion about the foreigner still remains.

In <g data-gr-id="94">course</g> of the stock market rout, the Chinese authorities spread allegations about foreigners or short-sellers as deliberately “attacking” the Chinese stock market. Foreigners bogey was pushed through the state media which are watched closely to get ideas about government stand. Foreign investors actually have at best a marginal role as their holdings in the overall market are rather small. The foreigner bogey might not have been serious. developments will have affected the Chinese banks. The stock market bubble was built with margin loans estimated at $232 billion. Some of these loans will end up at the banks. Many corporates had as well hypothecated their shares for raising loans. A fall in the market will have hurt throughout the chain including the banks. It is not yet clear how the banks will be affected but the banking sector in the country is already somewhat burdened with bad loans. The <g data-gr-id="99">rout</g> should add some more.

It is clear China has until now not much exposure to financial sector gyrations, being rather new to the experiment of free market economics. It will take <g data-gr-id="76">time</g> to gather adequate exposure.