The formally still-communist Peoples’ Republic of China has just experienced what we can call their “October 1929 Moment.” The most colossal stock market crash the world has ever seen is still underway a full two months after the spectacular rocket ascent of the Shanghai and Schenzhen stock prices began an equally spectacular reverse. Like many things China has made over the past three decades of opening to western ways, the Chinese stock market trading model was “made in USA,” in Wall Street to be precise. But the resulting stock bubble that exploded over the past six months was entirely “Made in China” by the Chinese leadership who clearly had no idea how leveraged stock markets really work.
Now President XI and the government face the growing danger of a massive popular loss of political confidence from the some 90 million ordinary Chinese who heeded the advice of their leaders to take their savings and plow it into Chinese stocks.
Since a break in investor confidence hit the Chinese stock markets in Shanghai and Shenzen in June, a paper meltdown has ensued that is far from over and that threatens to plunge the country into economic chaos. The problem is that naïve and perhaps somewhat greedy national leaders took highly dangerous measures to start the stock bubble several months ago and when the savage meltdown wiped several trillion dollars worth of stock capital out in a matter of days, took even more dangerous steps to stop the meltdown.
While some may suspect foreign nasty meddling by Wall Street and Washington to block the emerging threat from China’s leading financial role in creating an alternative to the dollar as world reserve currency, all evidence at this point suggests strongly that the bubble was entirely due to very risky and very, very foolish policy decisions taken by the Beijing leadership.
The Error of Margin
Since he became China’s President in late 2012 Xi Jinping, whose slogan since taking office has been to promote the Chinese stock market, calling it “the anchor of ‘the Chinese Dream’,,” along with his Prime Minister Li, whose slogan has been “let the market do what it does best,” have encouraged ordinary Chinese to buy stocks in Chinese listed companies.
The Beijing leadership, with strong encouragement from the US Treasury and IMF, declared that “market forces will be decisive” as the guiding principle behind reforms intended to reinvigorate China’s slowing economy. The stock market strategy apparently was to thereby inject capital into debt-bloated state companies, allowing them to stay afloat as the overall Chinese economic growth of recent years slows significantly.
The problem with their strategy, as the ongoing stock market meltdown reveals, is that Chinese officials from the Peoples Bank of China to stock market regulators to the highest levels of the State Council had little idea how dangerous were the imported Wall Street instruments they were using to push stocks higher over the past year or so.
The most dangerous of all was their decision to allow ordinary Chinese investors to buy stocks with money borrowed from stock brokerages, using the stock as collateral. This is termed margin buying. It has figured in every postwar US stock market bubble and ensuing crash, most notably the 1999-2000 dot.com bubble.
However, China’s leadership took that American turbo-charge model to extremes.
In 2014, alarmed at the extent of non-regulated “shadow banking” credit expansion in the Chinese economy, regulators took sharp measures to clamp down on the fast-growing sector that was fueling loans for Chinese economic growth at a fever pace. The crackdown on loans from non-banks produced dramatic results, especially after officials allowed several high-profile non-bank funds to go under without state rescue. By November 2014 new loans across China had contracted sharply from a year earlier. The contraction in new credit was giving China the lowest credit expansion recorded since 2005. That shadow banking crackdown was at the heart of a significant economic growth slowdown.
In that situation, evidently China’s leadership was convinced, perhaps by some over-zealous and naïve financial advisers who had studied finance in American universities or worked on Wall Street, that the Chinese Stock Market could save the day for the stalling Chinese economy by encouraging the “little man” to invest his savings there, giving over-indebted state companies a new lease on life.
Chinese state media began a major propaganda offensive late in 2014, urging ordinary Chinese to buy a stake in the “anchor to the Chinese Dream.” Then, to make sure it worked, the central bank and China Securities Regulatory Commission (CSRC) permitted significant margin buying of stocks at the beginning of 2015. Margin stock buying took off like a Chinese rocket, stock prices with it. Chinese stock shares soared on average 100% from November when the crackdown on shadow banking triggered the shift in focus, until the market peak in mid-June.
Suddenly, in echoes of 1929 on Wall Street, every ordinary Chinese pig farmer dreaming of retirement, to grandmas to teachers to blue collar workers, all plunged into stocks, some 90 million Chinese joining the feeding frenzy. At the peak before the bubble burst in mid-June, margin loans outstanding were Renminbi 2.2 trillion, an estimated 12% of the free float market capitalization of marginable stocks and 3.5% of GDP—easily the highest in the history of global equity markets, according to a Goldman Sachs analysis. In dollar terms that margin debt amounted to $356 billion.
But that was only officially registered and regulated brokerage margin loans. Almost an equal sum, perhaps 1.5 trillion RMB in loans to investors to buy stocks were done in hidden ways, from “umbrella trusts” and peer-to-peer lending websites offering instant credit to buy stocks.
In a rising stock market, margin stock buying is like having a money printing press. But when the rise reverses, the value of stocks that were used as collateral for the margin credit falls and brokers must demand “margin calls” from lenders—more cash. Most ordinary borrowers were forced to sell some or all of their stocks to raise the cash.
This is the savage reverse leverage of a financial bubble, one familiar to any careful Wall Street observer over the past three decades.
In late April this year, an alarmed China Securities Regulatory Commission tried to take moves to restrain the rate of growth of margin debt without popping what was clearly a stock bubble. They were forced to reverse and announce steps to ease rules on margin debt almost immediately as the market plunged, as more experienced investors began to sell and reap huge profits, fearing a market fall. That was the beginning of what has become a panic exit attempt by millions of Chinese inexperienced ordinary stock investors.
Median Prices of Chinese stocks by mid-June had reached a spectacular 85 times earnings. By comparison, Benjamin Graham, Warren Buffett’s teacher at Columbia University, postulated that stocks should trade for a P/E multiple equal to 8.5 times earnings plus two times the growth rate of earnings. The inflated US S&P 500 stock index today trades for a Price/Earnings of about 19 times the past 12 months of reported earnings.
Beijing Panics as Millions of Gumin Ruined
Gumin is the Chinese word for investor. The recent Chinese stock market bubble had been fueled by a government that lured some 90 million ordinary Chinese, most with little or no experience in the risks of stock buying, encouraging them to pour their private savings into Chinese stocks. Ordinary gumin, including low-income workers, street hawkers, farmers, and housewives are estimated to have each lost an estimated 420,000 yuan each as of July 4 according to Guangzhou Daily, a tremendous amount as measured against their total wealth. There is a growing social backlash of suicides and violence. In one reported case in Nanchang a man killed his wife because she had run up stocks-related debts of 1.8 million yuan.
Clearly in a panic, the central government has reacted in a manner that has made a bad situation even worse. On June 28, the central bank simultaneously lowered the interest rate and reduced bank reserve requirements. Then it ordered government-controlled pension funds to buy heaps of stocks. On July 4, the State Council summoned the CEOs of the nation’s largest stock brokerages to an emergency meeting in Beijing, during which they were told “to buy and never to sell.” Then the CSRC stock regulators told institutions and individuals who owned five percent or more of a company not to sell for six months. Two days later, half of the 2,800 companies listed on the Shanghai and Shenzhen exchanges suspended trading, resulting in a virtual shutdown of the stock market. Then the real chiller move to try to stem the panic: China’s Ministry of Public Security — normally tasked with cracking down on political dissent — announced that it would arrest what it called “malicious” short-sellers.
Those extraordinary state interventions halted the meltdown for a mere three weeks. On August 18, amid fears of Chinese Renminbi devaluations and lifting of the government selling freeze, stocks plunged another 6% as margin debt continued to unwind.
Crisis as Opportunity
At this point, the Beijing leadership is clearly re-examining the wisdom of following the Wall Street model to become a financial global power. Their ambition to make Shanghai into the new Wall Street of at least Asia if not the world, is dead, as no foreign investor will trust a market where the state intervenes and orders a freeze in selling and arrests of sellers. An analyst at the Swiss investment firm Julius Baer commented, “confidence in the local Chinese equity market has been shattered and is unlikely to come back anytime soon.” Just a few weeks ago, observers confidently predicted it was “inevitable” that domestic Chinese stocks would soon be added to the major global indices that serve as benchmarks for professional investors. Today it’s inconceivable.
That actually could be a blessing in disguise. To paraphrase the old Chinese proverb, it could allow Beijing to turn what seems a deep crisis, and one that, if handled poorly could rapidly lead to devastating consequences for the Chinese economy and the world, into a new opportunity to recalibrate their financial strategy in terms of the One Belt One Road rail and sea transport strategy.
Failure to fundamentally reassess the risk of following the US model for market deregulation and opening to free capital flows could easily expose China to the kind of financial warfare shocks that the Asian Tiger economies experienced in 1997-98 during an Asia Crisis, orchestrated by Wall Street, George Soros’ Quantum Fund and Washington to bring those tigers into the Washington pen. Liberalization of her financial markets and currency markets is clearly China’s Achilles Heel at this point and one Washington war planners at the US Treasury and State Department are keenly aware of now.
F. William Engdahl is strategic risk consultant and lecturer, he holds a degree in politics from Princeton University and is a best-selling author on oil and geopolitics, exclusively for the online magazine “New Eastern Outlook”.