Satyajit Das: Sino-stock contagion

Image: Chaitanya Dinesh Surpur

In the aftermath of the steep fall in the Chinese stock market, there is an increased focus on its wider effects.

Unreal to Real
China’s problems are unlikely to have any immediate effect on other equity markets directly due to its limited integration with international markets and the fact that these markets did not see a sharp parallel rise. 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 till date. 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, which boosts growth, did not occur.

However, it is incorrect to assume 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 savings rates, thus reducing consumption and slowing down growth. The output of the finance industry contributed around 16 percent of China’s GDP in the first quarter of 2015. It accounted for 1.3 percent of China’s 7 percent GDP growth in the same period, compared to a contribution of about 0.7 percent to the 7.4 percent growth in 2014. The slowdown will affect growth in future periods.

Leverage Again
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 fall 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 state-owned enterprises (SOEs) whose holdings of shares are pledged as collateral for loans. The fall increases the risk of default. The level of leverage may account for the difficulty in initially arresting the pace of price falls.

The consensus is that such loans are modest relative to the size of the banks (around 1.5 percent 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, $250-300 billion, may only be a fraction of the real level of stock-secured debt. Once vehicles like umbrella trusts, private lending arrangements, etc are included, the amount may be 50-100 percent higher. The real leverage may be higher still.

China analyst Anne Stephenson-Yang of J Capital Research argues that the increase in market capitalisation is directly related to the net increase in financing, generally, since the boom started. The nearly $4 trillion rise in the value of shares was not related to value created by companies as overall earnings declined. It was also unrelated to property prices and asset values which were stagnant. At the same time, increases in bank deposits or foreign capital inflows were not comparable to the expansion of equity values. One possible explanation for this is credit creation by the central bank, through expansion of lending in the interbank market. This would mean that the share market is supporting around half the increase in its value (assuming a loan to share value ratio of 50 percent) through debt. This suggests that central banks and state-owned banks may have extended up to $2 trillion to securities companies, brokers and smaller banks and co-operatives which, in turn, have financed share purchases.

Second, the exposure of the banks is greater than commonly assumed. Around 60-70 percent 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, the official permitted level of leverage is a modest two times, or loans can total 50 percent of the value of the stocks. In reality, real leverage was higher, at least double the leverage to four times, or loans totalling 25 percent of the value of the stocks. In addition, there were multiple layers of leverage. Investors would borrow funds from banks using 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.

Heavenly Mandates
The real damage of China’s stock market crash 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. Each new regime, like that of current President Xi Jinping, must establish a new dynasty, 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.

But instead of diverting attention from existing challenges, the stock market correction has drawn attention to new challenges such as the end of the property boom and other threats.

Chinese real estate represents around 23 percent 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 percent and inventories equivalent to five years’ demand in some cities, new housing starts are around 12 percent 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 $28 trillion (282 percent of GDP), higher than comparable levels in the US, Canada, Germany and Australia. In comparison, China’s debt was $7 trillion (158 percent of GDP) in 2007 and $2 trillion (121 percent of GDP) in 2000. This increase in its debt by more than $20 trillion since 2007 is, approximately one-third of the total rise in global debt over the period.

The stock market collapse raises the risk of major problems within the financial system. 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 for appropriate pricing of capital. It is important to make possible privatisation of state-owned enterprises. It is part of a programme to attract foreign investors and long-term stable capital inflows.

The fear is that China’s proposals are rhetoric, primarily for foreign consumption. At the 2013 Third Plenum, the Communist Party of China stated that the 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.

Falling Shares, Rising Discontent
The stock market crash has drawn attention to the underlying repressive economic processes. China’s financial system is predicated on directing savings of ordinary Chinese into 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 Communist Party-connected firms 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 benefited 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, also 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 which 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 Zemin. Signs of weakness or failure by the present administration will encourage these forces. 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 4,000, 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.

Satyajit Das is a former banker whose latest book The Age of Stagnation will be released in India in November 2015