Stock crash shows cracks in 'China model'

Analysis

The China Securities Regulatory Commission backed the commitment on July 4 by 21 of China's largest securities firms to hold stocks until the Shanghai Composite Index stabilised at the 4,500 mark (see CHINA: Market moves will not shake Beijing's resolve - July 10, 2015).

However, daily trading volumes in the Shanghai market have fallen by 70% since then, indicating that investors adopted a strategy of waiting until state-led intervention pushed the market back to 4,500 before cashing out. The implied put option made investors reluctant to hold stocks close to this mark, as they expected a significant sell-off.

The second crash

The precipitous fall in stock prices on August 24-25 reflects the downturn in trading volume, but also signifies deepening scepticism about the government's capacity to corral capital and manage the markets.

Just as the latest rout betrays the ineffectiveness of the 21-broker pledge to support the market, the plan announced on August 23 for the state pension fund to invest 30% of its assets in domestic equities will have limited stabilising effect and for now only damages the government's credibility.

Broader implications

The Shanghai stock exchange has experienced volatility before. However, the 2015 bull market -- the first since 2006 -- involved a constellation of factors that expose deeper contradictions in China's economic model.

China's recent economic growth has been driven by the creation of large asset classes: first in infrastructure financed by 'local government financing vehicles' (LGFVs), then in property and finally in the stock market.

This created significant wealth but now constitutes an ever-growing source of financial pressure within a banking system that serves as the ultimate conduit for the government to preserve confidence in the financial system.

Debt conversion

A central objective of inflating the stock market -- via policies to encourage margin lending and retail investment -- was to reduce financing costs for companies seeking to replace expensive debt with cheap equity. In the process, losses were transferred from the banking system to households -- a pattern seen across the entire arc of China's economic development.

The strategy of converting debt to equity, funded through the stock market, bought time for China's banks. Policymakers adopted it for four reasons:

• Direct conversion of unpayable debt to equity would relieve financial distress in the corporate sector.
• It would create a new financing channel for asset-light emerging sectors such as tech and consumer services.
• Increasing investor wealth would boost consumption.
• Property investors would be more tolerant of stagnating real estate markets if their equity portfolios performed well.

The stock bubble constituted the most explicit expression yet of the authorities' method of dealing with debt problems: a closed capital system that relies on the resources of ostensibly independent financial institutions to channel new capital into the economy.

August 19 saw confirmation of this strategy when China Securities Finance, the largest participant in July's government-mandated market intervention, announced the transfer of large quantities of recently purchased stock to Central Huijin Investment, the state-owned holding company that serves as the lynchpin of Beijing's authority within the banking system through its majority stakes in the state-owned commercial banks.

Financial strains

These problems of an overly speculative stock market are closely connected to developments in shadow finance, where 'wealth management products' have diversified from real estate to equities to compensate for falling returns from the property market (see CHINA: Housing market reaches turning point - December 11, 2014).

The financial system currently requires approximately 1.5 trillion renminbi of total social financing per month to remain afloat, much of it channelled via the state-owned banking system.

The authorities bank on riding out the broader economic slowdown, buying time by supporting asset prices in successive sectors and thereby generating sufficient collateral value to maintain liquidity in the interbank market.

This is tied to the Communist Party's broader objective of fostering the 'new economy'. Investors anticipate the shift to a new growth model that relies on areas such as clean energy and biotech, and on e-commerce and robotics and automation.

Accordingly, the central authorities reacted strongly to the fall in China's equity markets that began in mid-June. The asset inflation afflicting stocks was the same pattern that had afflicted commodities and then real estate previously, but was susceptible to a more volatile correction.

Deeper cracks

Stabilisation mechanisms depend ultimately on Beijing's credibility: Chinese markets for financial investment operate according to individuals' interpretations of policy positions rather than economic fundamentals.

The deeper issues are the prospects for economic reform and Beijing's ability to bear the costs of economic adjustment. Volatility is among these costs.

The Communist Party-led system is vulnerable to volatility that casts doubt on its status as the ultimate repository of economic authority -- but financial markets are fundamentally volatile.

The only means by which the authorities can maintain the integrity of the financial system is to remove market uncertainty, a feat temporarily achieved on July 9 when strict measures compelled brokerages to buy heavily and not sell.

Given the pervasive uncertainty now pervading the market following the August 23 crash, efforts to achieve this appear marginal at best and counterproductive at worst.

International prestige at stake

Deepening financial strain is affecting China's foreign financial presence in two ways.

Demand for American Depositary Receipts is weakening, as the possibilities for Chinese companies going private and relisting in China are eliminated or rendered unattractive.

External stakeholders are also losing confidence that Beijing has the financially capacity to support the ambitious goals of the Asian Infrastructure Investment Bank, the 'One Belt and One Road' initiative, and a domestic infrastructure plan centred on the development of new cities (see CHINA: AIIB will reshape development finance landscape - March 30, 2015 and see CHINA: City-building ambitions will shake the world - August 14, 2014).