China’s stock market crash: the end of a myth

To any student of geo-economics, the current gyrations of China’s and the world’s stock markets are fascinating.  The Shanghai exchange is notoriously volatile: two years ago it was thoroughly depressed when the Chinese economy seemed to be booming, while over the past year it has been boiling as China’s economy slowed down. It is notoriously riddled with insider trading, and very poorly — if at all — connected to international markets (the bridge to the Hong Kong stock market is a recent development). All seasoned observers know that what is essential in China is to get in before others, which often requires connections, and to get out before others, which is internationally the main skill of hedge funds. The market is a myth that enriches transient stockholders, not value investors. Trading volumes have been unreasonably high, although at 60 percent of GDP, China’s overall market capitalization hasn’t reached the sizzling 160 percent ratio to GDP of early 2008.

In other words, the Shanghai stock market is always an accident waiting to happen. Moreover, its first fall on June 15 was most likely triggered by a totally extraneous factor: the perception of Chinese investors and speculators that Greece’s looming debt default was going to produce a major European crisis and therefore a downturn in demand for China’s exports. Chinese investors also worried that US economic growth was likely to slow down with the prospect of a coming interest rate rise by the Fed. Commentators often overlook the degree to which Chinese equity buyers are affected by their perception of the international economy, and are often fed very pessimistic estimates by their media.

In other words, the Shanghai stock market is always an accident waiting to happen.

What followed showed both the power of the Chinese state and the increasing lack of coherence in its economic policies. The government’s not-so-hidden hand picked up the market and steadied it, a development that was initiated while the more market-inclined Prime Minister Li Keqiang was on a trip abroad. This was not in itself unusual: Chinese macro-economic policy has for many years displayed a tendency to shift from one foot to the other, e.g. alternating between the gas pedal and the brake, trying to downsize bubbles, and then to arrest the resulting economic slowdown. In previous years, however, the government had mostly let the stock market run its course – notwithstanding the myriads of rigged operations that take place every day. By contrast, it had pretty much guaranteed the exchange rate for the renminbi. In fact, over recent months, pegging the currency to the dollar had begun to cost quite an amount of the central currency reserves.

Everything changed in June and July. On the one hand, by intervening visibly and massively in the stock market, the government arrested the slide, but at the cost of mostly freezing the market. In this way, it unwittingly persuaded market actors that there was a huge problem. From that moment onwards, private investors have largely left the market in government hands. With the currency, by contrast, the central bank announced in early July what amounts to a change of regime, from the certainty of a dollar peg to the uncertainty of some market play. The fact that the new policy was initiated and publicised by the central bank, a somewhat reformist institution that does not always have full government backing, was significant, as credibility is the name of the game for markets. Investors mostly saw the move as a hidden devaluation for competitive reasons – and decided to amplify the move.

What followed was a communications disaster caused by fuzzy government policy, lacking an overall sense of direction. The central bank was forced to eat its own words, buying renminbi every day before market closure to stabilize the exchange rate for the next day. On the stock market, public funds became the leading actor, with private investors retreating to the sidelines – or waiting for an opportunity to sell.

This happened as China was feeling other tremors. Some of them are political: a deepening and widening anti-corruption campaign is taking down more and more key power holders and their affiliates, from the army, security and oil sectors and from provinces as diverse as Shanxi, Guizhou or Hebei. Clearly, no one apart from President Xi’s closest associates is safe, and relatives of past leaders who had become major power holders are also being targeted: Jiang Zemin or Li Peng’s children, for example. On top of this, the Tianjin accident, symbolizing pervasive corruption at the heart of China’s industrial complex, creates a new dimension of uncertainty: if Tianjin authorities can be indicted for the disaster, no local government is safe, as they pretty much all follow the same pattern.

Clearly, no one apart from President Xi’s closest associates is safe, and relatives of past leaders who had become major power holders are also being targeted.

If this were Deng Xiaoping’s China, or Zhao Ziyang’s or even Zhu Rongji’s, there would be a political way out of the morass: charging out of the crisis by declaring a new reform initiative. But Xi Jinping has until recently established himself as promoting a technocratic and non-political form of reform, and shunned all of the political rhetoric associated with a market economy, market liberalization, and, above all, free and independent institutions. His pervasive personal power has been attained at the cost of emphasizing the greatness of China over its reform.

Clearly, there has been hesitation or debate at the top. After a move to liberalize the currency market, the central bank switched back to propping up the renminbi – then assured everybody it would resume the move to a flexible rate for the currency: however, this has not yet happened. Instead, the authorities have mostly stopped intervening on the Shanghai stock market – in effect, letting it again fall freely. The move itself was shrouded in uncertainty, since China’s official news agency announced over the weekend that a new government actor would be allowed to intervene and buy shares: this was interpreted widely as the signal of a new intervention, but no intervention took place. The big news of August 23 is that China’s government has given up stock market intervention, moving to a pro-market policy as had been its intention for the currency regime.

All this – along with a few official media sources denouncing past leaders and “tigers” for their interference with policy or talking about the strong resistance waged by interest groups against reform – indicates a power struggle. Given Xi Jinping’s impressive track record of the past two years, it seems most likely that he will win it. As with other developments of the past two years – the fast development of the service and private economy, of internet retail sales and web banking – he may be throwing his lot in more than previously believed with economic reformers of whom Prime Minister Li Keqiang remains the most prominent. The fight against entrenched rivals and corrupt interests may in fact lead him to move further in that direction.

But Xi Jinping’s style of communication runs counter to the goal of reform. He cannot rekindle the messianic hope of a turn to market economy that characterized earlier eras. Furthermore, many Chinese investors are no longer innocent market players. They have acquired strong interests, which are mostly on the wrong side of the economy – above all, bloated real estate holdings. The fight against corruption increases a sense of insecurity that is also fuelled by the economic slowdown, by dismal international news and by a new uncertainty over exchange rates. Those affected hunker down or aim for the escape hatches that they can find: strikingly, the HK-Shanghai Connect has been used recently as an exit route.

It is at this point that psychology overtakes rational analysis.  China is still booming – as shown by a 10.4 percent year on year increase for household consumption (or, anecdotally, a 48 percent increase of Chinese tourists going to France in the first half of 2015!). The foreign trade surplus is larger than ever, because China is suddenly buying energy and raw materials on the cheap: it is foreign producers (such as Gazprom) which are feeling the pain. A stock market crash in China is business as usual. A change of currency regime should be good news for those who believe in the renminbi’s coming status as an international reserve currency. Overall, growth pains are unavoidable for an economy that is undergoing structural change. And that structural change – from overinvestment to consumption, from infrastructure to high-tech or virtual economy, from trade to services, and away from a model that is bleeding the world dry of its natural resources – is what every reform-minded economist has called for in the past.

After a move to liberalize the currency market, the central bank switched back to propping up the renminbi – then assured everybody it would resume the move to a flexible rate for the currency: however, this has not yet happened.

Yet nobody, except some non-market economists, appears to see things this way. After believing in the win-win myth, market economists and actors seem entranced by a lose-lose vision. And this in turn is amplifying the negative shocks to be felt from China’s overall slowdown. The falls witnessed in stock markets which are largely uncorrelated with China testify to a larger truth: that the global economy has been on thin ice for some time, sustained by zero interest rates and quantitative easing.  The French stock market – in an economy where only 3.5 percent of exports are going to China – is a case in point. China was a positive myth, in the same way as capital intensive or luxury goods exports to rich energy producers. The collapse of energy and raw material prices should be extraordinarily good news for mature consumer markets that are not blessed with these natural resources. In fact, it does not figure: huge energy taxes have essentially dampened the impact of price changes (a fall of oil price from 150 to 40 dollars a barrel translates into a 10 percent discount at the pump!). The overhanging public debt turns imported deflation into bad news, because it increases the relative weight of that debt. In fact huge public financing needs prevent the adoption of a Keynesian spending policy, while quantitative easing essentially allows governments to continue the social subsidies that have served as shock absorbers in the downturn, but cannot create an upturn.

It is not the state of China’s economy that is creating this global wave of market pessimism. It is the disappearance of China’s positive myth, which served as a proxy for all emerging economies and served to balance the pessimism inherent in aging welfare societies. Over the past year, huge amounts of capital from emerging and oil economies, much more than from China, have flowed into developed economies and recreated bubbles in real estate and the stock markets. That inflow will run out as these emerging and natural producer economies are bled dry. China may in fact turn out to have more resourcefulness and sense of purpose than the developed economies, barring the United States, in moving towards a service and high-tech economy. It needs to flag this transition more clearly than has been done so far. Europe is facing its own demons: on the one hand, unsustainable public and social expenses for many economies; on the other hand, a complete incapacity to turn a hugely positive external balance (now that commodities are falling and emerging producers competing to keep market share) into a pro-growth policy inside Europe. That has nothing to do with China, which has functioned as a positive myth for some time and is now a proxy for our own inability even to conceive of a growth policy at the continental level.