China’s stock crash: it was only money

In just under a month 3 trillion dollars have been wiped off the Chinese stock market – roughly 30 percent of China’s GDP. By normal standards this would be carnage but it may be, in fact, less worrying than it seems.

First of all, a crash like this has happened before in China and in Greater China. Taiwan’s stock market gained 12 times its value between 1987 and 1990 – then was divided by five in the next six months.  The Shanghai stock market itself gained six times its value in 2006-2007 – until it went into a tailspin on October 2007 that sent it 45 percent lower.

It is a story familiar to anybody with a knowledge of the history of Chinese stock trading – from the early days of the Republic of China, through the mad days of Hong Kong’s Hang Seng index, to Taiwan where demonstrations by shareholders are not uncommon. In a culture which invented the concept of the wheel of fortune, there is an anthropological dimension in Chinese money games and speculation.

It is less worrying too because the rise of the past six months – an increase of 107 percent – was both unsustainable and countercyclical, except to government-induced credit. Again, Shanghai has seen this before. Though the value of the stock market exceeded the GDP last month, this level has been reached before. And the volatility – with an average 17 day turnover of shares– was actually less than it was in 2007, when it was said to be in the single digits.

It’s also less worrying because the fallout is actually quite concentrated and with little contagion. Much has been made of the advent of margin calls, with a level surpassing Wall Street. But these margin calls – 3.3 percent of GDP at last news – do not directly affect banks but are concentrated on a class of speculators. Their amount is equivalent to about half of listed banks’ bad loans – or 4.5 percent of the loan balance of the same listed banks.

This is not to say that the crash will not hurt many of the 80 million individual equity owners in China, or that it will not marginally affect consumption, especially conspicuous consumption. But there is an upside that many Europeans do not see. In an era where China consumes 45 percent of the globe’s raw material resources, with all the attendant price speculation, a downturn in their price, as we have now, is actually good news for real economies which do not produce these resources. Above all, this is good news for Europe.

How did this bubble build up over the last six months? It’s a familiar story: China’s financial authorities have been hovering between the brake and the gas pedal on credit – a stop-and-go policy that reflects their dual fear of overheating and a recession. And President Xi Jinping’s policy has been dual in another key respect since the 3^rd Plenum of November 2013: it has encouraged SOEs in China and abroad while ruthlessly checking on their masters, but it also has also liberalised and extolled financial markets, including allowing for a bridge to be built between the Shanghai and Hong Kong financial market. Last week, this bridge reversed its original purpose, helping hot money to escape the crash and fly to Hong Kong. Pointedly, Xi Jinping’s anti-corruption campaign has targeted the energy, infrastructure and real estate sectors, but it has neatly skirted around finance. It may well be that well-connected share owners are so numerous and insider trading is so huge that if a campaign started there is no telling where it might stop.

These very insiders took their cue from this tacit abstention. They played the casino – taking along millions of small shareowners opting for the more profitable returns of the stock market over less profitable, but safer, real estate. Then came the crash, ignited, in all likelihood, by bad news from abroad leading to a reversal of expectations in China. This is what happened before, in 2007, and one shouldn’t underestimate how much Chinese economic agents look at the outside world and its impact on China’s economy. When average price earnings ratios exceed 50, any fortuitous event can prove to be a tipping point if it moves market sentiment.

If what happened up to the crash is almost business as usual, the government action that followed is unusual, even by Chinese standards, and highly problematic. Comparing the 2007 crash to today illustrates just how the Chinese government’s approach has changed. In 2007, Ping An, China’s leading insurance stock, rose to three times its introduction value after only six months. This is the stock in which we know, thanks to a famous Bloomberg enquiry, that then prime minister Wen Jiabao’s relatives had a commanding share. But in the next year and a half, the stock would lose 85 percent of its valuation. Although at the time China’s government took extensive measures to revive the economy, it did not start with the stock market. Shareowners took their losses.

Not this time. With multiple actions, including forcing brokerage companies to buy stocks and authorising companies to suspend trading in their own stock, the authorities have put a floor on the stock market fall. In so doing, they have compounded the problem and hurt any confidence that market mechanisms would be allowed to play. By allowing 655 companies to halt trading in their own stocks, authorities have indeed compounded the problem by encouraging speculators to short sell the remaining stocks available to them. In other words, the connected are kept above water, the others may sink.  And they have damaged confidence in market mechanisms. At 70 percent above last year’s average, stock values are still abnormally high in what is, after all, a year with many question marks on China’s domestic economy.

There is no immediate harm in letting speculators know the government’s not-so-hidden hand actually moves the market. But in the long term it is incompatible with lifting capital controls and internationalising China’s currency. China’s mad share bubble was in fact uncontrolled monetary creation, which has also happened previously in shadow banking and real estate. Bursting it is a prerequisite to lifting capital controls. As Warren Buffett famously said, it is only when the sea tide recedes that one sees who wasn’t wearing shorts.

What happened instead – at the same time as Premier Li Keqiang was in Europe talking very good sense on China-EU economic relations – will contribute to the most dangerous aspect of stewardship by Xi Jinping, now dubbed the “president of everything”. Given the controls in place, the positive external accounts and the huge potential in monetary creation, China’s government can, of course, stem literally any speculation, and it can provide a floor to the stock market. But doing so will reinforce the conservatives’ winning argument – that control is safety and liberalization is always a hazard.

Until now, Xi Jinping had achieved the feat of controlling politics to the greatest extent of anyone since 1978, while keeping open a market drive that circumvented China’s state economy. But the government’s victory over speculators may be a Pyrrhic one if it halts the move to financial and market liberalisation.