Will China crash?

Shanghai stock market, like inevitable weather changes, has crashed once again on January 15. It has affected the entire Asian financial markets once again and Indian market is also down. The latest fall has come hard on the heels of another precipitous drop immediately after the markets re-opened in the New Year. 

Then the Shanghai stock exchange slumped seven per cent within barely 30 minutes of the opening of trading. The first day’s fall had wiped out market valuation by around $2 trillion – a little more than India’s GDP for a year. Taking the latest loss of market valuation, the market has tanked by over 20 per cent in the new year itself. As the prices crashed last time, the circuit breakers were triggered and trading halted for a second time in a week.

The Chinese securities regulators had called an emergency meeting. All they did was to discontinue with circuit breakers altogether, an established practice among stock exchanges. Worse, they refused to lift the ban on selling shares by large holders. Thus, the stock market, instead of freeing it up from control, was further subjugated to the interventions by the government. Surely, that is not the way to inspire confidence and nurture the financial markets. 

There are two fundamental problems with the Chinese financial markets. First, when the new government of Xi Jinping decided to open up the Chinese economy further and bring down government control over the functioning of the economy, they felt that finances could be tapped through the equity route. Hence, they emphasised retail investment in stocks. The Shanghai stock market was given a boost and linked up with the much freer Hong Kong market thorugh the stocks connect programme. 

To give a leg up, the government, stock market regulator and the state controlled media started giving the impression that stock investment was the surest way to multiply money. The government seemed to be ensuring that people profited from stocks investments.  Margin money was liberally provided for purchases and even people were egged on to raise loans on their home and hearth to put money on stocks. 

Retail investors surged to largest in the world – some 90 million people put money in stocks. The Shanghai market was soaring and it climbed to unprecedented levels. The Chinese stocks were selling at close to 60 times of their underlying earnings levels. Against this, shares price-earning ratios were around 15 per cent to maximum outliers at around 20 per cent. 

Hence, the day of reckoning was sure to come. People are trying to get out of their stocks investments whenever the markets are in session. But then, whenever markets are falling, Chinese government is asking its state owned companies to intervene and buy up stocks. The cure is obviously not working, even in the absence of curbs on share selling. 

The basic problem is that its 90 million retail investors react in panic whenever the markets fall and now are somewhat convinced that they should leave holdings. Exactly this nature of the investors had resulted in the market rout last July-August and this is creating fresh problems now. But it is a creation of the artificial economic policy. The authorities had talked up the market and encouraged individual investors to directly enter the stock market. This build up happened over last six to seven years.

Secondly, along with the mayhem in the stocks markets, the Chinese central bank had re-set the currency, yuan, lower in its efforts to aid the country’s exports. The People’s Bank of China (PBOC) is lowering the exchange rate to make Chinese exports competitive. This had created a fresh problem: the spread between overseas price of yuan and on-shore price. On-shore exchange rate of yuan was higher than the Hong Kong market rate and that had created arbitrage scope. This had been somewhat contained for the time being.

To control exchange rate of the yuan, Chinese authorities are intervening in the market. The central bank has intervened in the markets on January 15 as well blowing up from its foreign exchange reserves. While admittedly, China has a large trove, even billionaires have to worry on such outflows, said some of the financial sector experts. 

Underlying all these developments is the weaknesses in China’s real economy.  The economy is slowing down and to contain the slide, the authorities are constantly pumping in boosters. China is reported to have created fresh credit of a humongous $276 billion in December alone. This is all set to implode and a credit crisis is about to burst.

On the other hand, as is widely known China has massive production capacity which cannot remain in production unless China’s exports surge. In fact, the process has continued for over two decades when exports kept rising.

Trouble has started as exports fell with the global markets in some kind of recession. The overall demand in global being low, China faced the problem of overcapacity. So far, China sought to address this problem of over-capacity through higher investments in infrastructure or house building.

Nevertheless, the model is unsustainable and divorced from the country’s reality. You cannot go on creating infrastructure or housing without there being as many takers. China is now seeking to re-boot by encouraging domestic consumption. 

The Chinese authorities’ response in the meantime is becoming apparently more and more confused.