The mandate of heaven

This is part 3 of a three-part series on the Chinese stock market. Read part 1 and part 2.

Sino-contagion

Increasingly the focus has turned to the effects of the fall in China’s stock prices. The effects on China’s economic activity are the primary concern. These, in turn, may flow through into the global economy, affecting growth, trade, commodity prices, inflation and capital flows.

The impact on the real economy has been muted to date. Participation in the stock market is relatively modest. Government, local governments and SOEs own a large proportion of the shares and will bear a large share of the nominal loss.

The paper profits of inflated share prices did not have a major effect on consumption. In part, the speed of the rise meant that the wealth effect loop from stock market profits into spending that boosts growth did not occur. There are parallels to the US 1987 crash, where short-terms gains were unwound with limited effect on economic activity.

It is incorrect to assume, however, that the fall will have no effects. To the extent that wealth losses have occurred and uncertainty has risen, Chinese households may increase already high saving rates, reducing consumption and slowing growth. The output of the finance industry contributed around 16% of GDP in the first quarter of 2015. It accounted for 1.3% of China’s 7% growth in the same period, compared to a contribution of about 0.7% to the 7.4 percent growth in 2014. The slowdown will affect growth in future periods.

The financial effects may be greater. Given that a significant part of the rise in stock prices was driven by borrowings to purchase shares, the recent falls will reduce the value of collateral. To the extent that investors cannot meet margin calls, lenders may suffer losses. Also affected will be many large shareholders and SOEs whose holdings of shares are pledged as collateral for loans. The falls increase the risk of default. The level of leverage may account for the difficulty in initially arresting the pace of price falls.

The consensus view is that such loans are modest relative to the size of the banks (around 1.5% of total banking assets) and the economy, implying the risk of a major financial crisis is limited. But there are reasons for caution.

First, the amounts involved may be much larger than expected. The amount of official margin debt extended by securities companies of US$250-300 billion may only be a fraction of the real level of stock-secured debt. Once vehicles like umbrella trusts, private lending arrangements and so on are included the amount may be 50-100% higher. The real leverage may be higher still.

Second, the exposure of the banks is greater than commonly assumed. Around 60-70% of all lending in China is from banks. While precluded from direct exposure to stocks, banks have significant exposure to securities companies, broking firms, investment funds and trust companies which provide margin financing. Banks also finance listed companies where the collateral securing the loan is stocks. General-purpose bank loans to households and companies may have been used to buy stocks. Problems may emerge over time.

Third, lending standards declined during the boom. The official permitted level of leverage is a modest two times, or loans totalling 50% of the value of the stocks. In reality, real leverage was higher, at least double the permitted leverage: four times, or loans totalling 25% of the value of the stocks. In addition, there were multiple layers of leverage. Investors would borrow funds from banks and use the borrowed funds as the capital to purchase shares on margin.

The financial exposures derive from an essential circularity in the engineering of the stock boom. The intention was to use higher stock prices to allow heavily indebted entities to raise equity to pay back otherwise unsustainable borrowing, in effect reducing the risk of loss of banks. Instead, the banks were lending money directly or indirectly to investors to buy shares where the proceeds may have been used to pay back the bank. In reality, the banks had just exchanged risks without necessarily reducing the risk of loss. The circularity has been compounded further after the share market falls. China’s biggest state-owned banks, under government encouragement, have lent over US$200 billion to the country’s margin finance agency to support share prices.

Heavenly mandate

The real damage is subtler, bringing into question the fundamental economic model, the reform agenda and the political authority of its leadership.

Over three millennia of history, China’s leaders have ruled by the mandate of heaven. Modern leaders are still in some ways divine emperors, an exception to the atheism of the Communist Party. Each new dynasty, like that of current President Xi Jinping, must establish itself, consolidating power and authority. This requires ensuring general prosperity, especially for key groups whose support is essential.

The officially sanctioned “state bull market” or “Uncle Xi bull market” was enthusiastically cheered by state media and brokers encouraging participation. The evaporation of US$3-4 trillion of value undermines the president’s credibility.

Instead of diverting attention from existing challenges, the stock market correction has drawn attention to challenges such as the end of the property boom.

Chinese real estate represents around 23% of GDP, about three times that of the US at the height of its property bubble. Prices appear inflated relative to incomes and rental yields.

Despite vacancy rates of over 20% and inventories equivalent to 5 years demand in some cities, new housing starts are around 12% above sales. In China, investment spending as a percentage of GDP is unprecedented in history, creating massive overcapacity.

The accompanying credit bubble remains an immediate concern. By 2014, total Chinese debt was US$28 trillion (282% of GDP), higher than comparable levels in the US, Canada, Germany and Australia. In comparison, China’s debt was US$7 trillion (158% of GDP) in 2007 and US$2 trillion (121% of GDP) in 2000. This increase in its debt of more than US$20 trillion since 2007 makes up approximately a third of the total rise in global debt over the period. The problem is compounded by the use of this debt to finance assets with inadequate returns to meet interest and principal repayments.

While in isolation a significant but perhaps manageable problem, the stock market fall, especially if the Chinese authorities are unable to bring it under control, may change perceptions about the economy’s prospects. It raises the risk of major problems within the financial system. It reduces the option of using stock issues to recapitalise weak vulnerable borrowers and businesses. It also exacerbates the credit bubble as more money is deployed to support share prices.

This will ultimately affect China’s potential growth, which has since 2009 contributed significantly to global economic activity. This concern is reflected in significant falls in global resources stocks, as investors anticipate a slowing demand for commodities.

The episode may slow down or defer necessary economic reforms. A liquid and well functioning stock market is essential to reducing excessive reliance on bank loans and appropriate pricing of capital. It is important to possible privatisation of state owned enterprises. It is part of a program to attract foreign investors and long-term stable capital inflows. It would allow greater integration of Chinese markets into the global trading system and facilitate the internationalisation of the renminbi. The recent volatility has not been helpful to these objectives.

The fear is that China’s economic reform proposals are rhetoric, primarily for foreign consumption. At the 2013 Third Plenum, the Communist Party stated that market forces must play a “decisive role” in allocating resources. The stock-market crash and the response suggests that the Chinese authorities are likely to resort to tried and tested command-and-control measures when events develop in an unwanted way, relying more on Communist dogma than market forces.

It may well be that China has missed the opportunity for fundamental reform, which would have been easier to implement during the period of high growth and modest debt levels. As Sun Tzu warned: “Even the finest sword plunged into salt water will eventually rust.”

The stock market crash has drawn attention to the underlying repressive economic processes. China’s financial system is predicated on directing the savings of ordinary Chinese into specified areas for policy purposes, especially maintaining economic growth. The regime relies on keeping the cost of funds artificially low, usually below inflation rates.  The system allows firms connected to the Communist Party and privileged insiders to benefit.

The stock market boom allowed elites to access cash from Chinese savers. The first group who benefitted were those who were able to list or sell shares to take advantage of artificially high prices. The second group were those who gained preferential access to shares in hot listings or benefitted from private information about earnings and corporate actions.

The fall in prices affects both groups. The financial elite are deprived of easy money making options, especially as other sources of profits such as property are unavailable. Ordinary savers encouraged by the government to invest in stocks face large losses, increasing resentment at the nature of the game and the growing wealth gap.

Intended to offset opposition to the aggressive anti-corruption campaign that affected their ability to profit, the engineered boom was designed to reward elites and ensure support for the president’s agenda and consolidation of power. Instead, the bust has undermined the new regime, evidenced by hyperactive intervention to support share markets.

President Xi is viewed by Western commentators as perhaps the most powerful Chinese leader since Deng Xiaoping. But history demonstrates that the grasp on power in China is fragile. President Xi’s anti-corruption measures, in part Stalinist purges to strengthen his own position, are popular among ordinary people. But they have antagonised cabals, such as those associated with former President Jiang Xemin. Signs of weakness or failure by the present administration will encourage these forces. Again, as Sun Tzu wrote: “If you wait by the river long enough, the bodies of your enemies will float by”.

In April 2015, when the Shanghai stock index rose above 4000, the Chinese Communist Party through its media organs trumpeted the new “Chinese Dream”, an essential part of which was increasing prosperity from rising share prices. That dream may yet turn into a nightmare for China, its investors and especially its leaders.