...the popping of the Chinese stock bubble is not just about a plummet in the stock market. The real key to understanding what has taken place in China is often named but seldom explained: shadow banking.
If you needed any further demonstration of China's arrival as a major player on the international economic (and geopolitical) scene, look no further than the latest news from Greece. Earlier this week Chinese Premier Li Keqiang made headlines for telling the eurozone that they need to get a deal done with Greece. This was followed soon after by another Chinese official suggesting that China might be ready to bail out Greece themselves.
On Thursday Fan Mingtao, a director at the Chinese Institute of Quantitative and Technical Economics, told Sputnik China that China could bail out Greece directly. After explaining that the Greek meltdown threatens China's own investment interests in the country, he noted: “I believe there are two ways to give Greece Chinese aid. First, within the framework of the international aid through EU countries. Second, China could aid Greece directly. Especially considering the Silk Road Economic Belt and the Asian Infrastructure Investment Bank. China has this ability.”
Or does it? The irony is that just as China begins to flex some of its international economic and geopolitical capital, the cracks in China's own credit-fueled economy are beginning to show. The meteoric rise of the Chinese stock market over the past year (with the Shanghai Composite going from 2000 a year ago to over 5000 just last month) has only been topped by the speed with which it has plummeted (down to 3629.53 and continuing to plummet as of press time). This remarkable volatility has taken its toll on investors, wiping out $2.36 trillion dollars of market value in weeks. Or, as Bloomberg notes, not without some irony itself, the amount of value the market has lost during this plunge is “equivalent to about 10 times Greece’s gross domestic product last year.”
But perhaps the real irony is that, just like the Greek mess, the Chinese mess has been caused by government machinations and manipulations. With the Chinese Communist Party attempting to throw the gears in reverse and move from an export-driven to a domestic market-driven economy, they have been using every trick in the book to keep the country's nouveau riche from taking their money offshore, from capital controls to a public relations blitz designed to entice first-time investors into the stock market in support of domestic companies.
The problem? It worked too well. Investors took the hint. In a nation where every official pronouncement is read between the lines for what is being implied, the public decided that the government was tacitly guaranteeing to back up the stock market and they piled on. With leveraged and re-leveraged and re-re-leveraged funny money. Stop me if you know how this story ends.
The all-wise central planners of the Communist Party began to realize they had unleashed the kraken earlier this year as stock prices continued to rise at record rates. In April they instructed brokers to rein in lending to traders and limit their liabilities, but to no avail. Stocks continued rising and rising until mid-June when the dam finally broke.
And what was the straw that finally broke the camel's back? Good economic news. As we've noted before in these pages, in the “New Normal” of QE insanity, good economic news is always terrible news for investors, because it means that central banks are going to turn off the spigot of funny money. Or at least ease off on credit creation a little bit. Given that the Chinese economy is now almost exclusively credit-driven (and has been for years), investors read the writing on the wall and started pulling out of the stock market.
Now we have the madness of the past week, with the Chinese government trying desperately to plug every hole in an SS Stock Market that seems to have been split in half by the iceberg of economic reality. The People's Bank of China has so far tried every trick in the book to manipulate the markets back to life. They slashed the benchmark lending rate by 25 basis points. They cut the deposit rate to 2%. They reduced reserve requirements for some lenders. They announced they were considering suspending new IPOs in order to bolster interest in existing stocks. They have committed to put up to 30% of the state pension fund's assets (equivalent to $145 billion) into the stock market. And in the latest move, the China Securities Regulatory Commission has eased restrictions on using leveraged money to buy stocks. What could go wrong?
Well, the popping of the Chinese stock bubble is not just about a plummet in the stock market. The real key to understanding what has taken place in China is often named but seldom explained: shadow banking. This sector comprises all of the various non-official and control-skirting ways that investors that are hungry for risk (and potential reward) can use to leverage their stock bets multiple times. Officially, brokerages are only allowed to let traders in the Shanghai Composite engage in margin trading if they have at least 500,000 yuan invested. Also, they can only officially double that position through margin trading. Unofficially there are a cornucopia of schemes that skirt these rules, including “umbrella trusts” (where stock trades are financed by debt holders who receive a fixed payout), “Wealth Management Products” (WMPs, where guaranteed rates of return are promised for instruments backed by stock trades), P2P platforms (where lenders can finance traders directly at any terms they agree upon), stock-collateralized loans and other exotic-sounding instruments.
From a voluntaryist perspective, all of these forms of funding are valid, valuable and perfectly moral forms of grey market participation. To the extent that they represent voluntary trading with informed consent, they should be allowed to happen. But equally, when they get completely out of control they have to be allowed to fail. This is precisely the opposite of what is happening in China right now.
The Chinese government is determined to stop the stock market from plummeting precisely because of the potential for the unwinding of this shadow banking system and the estimated 500 billion to 1 trillion yuan it has added to the value of stocks since last year. Given the significant financial and economic firepower at their disposal, it is a virtual certainty that they will be able to halt the plunge before it wipes out all of this year's gains. It is also very likely that prices can be stabilized and perhaps brought back up later on. But this can only happen at a huge cost to the credibility of the market and an even larger price tag in the form of moral hazard. If the government refuses to let prices dip back down to pre-boom levels then they have effectively signaled that the investors were right; the government is guaranteeing the market and there's no way to lose money even with the most outrageous bets. And once that message is sent, the whole cycle can start all over again.
At this point, it's fruitful to ask what the actual differences are between the Chinese “communist” and the American “capitalist” system. China has a central bank that tries to control its economy through setting rates and creating easy credit, and so does the US. They have committed to various types of QE and special liquidity programs every time the markets are faltering or growth is slowing, and so has the Fed. They have created a phoney-baloney boom based on paper promises backed up by government force, and so have the Americans. And for that matter, so have the Europeans, the Japanese and many other governments around the world.
The difference is that Europe is reaping the whirlwind they sowed when they created the eurozone now, and China is still in a position to talk about being the savior. It will be interesting to see if that actually happens, but it is looking less and less likely that the Chinese will be in a position to do so in the future if their system keeps lurching forward as it is now.