When we first commented on the emerging problems with China’s market bubble, we warned that although a bounce from oversold levels was the most likely outcome, it wasn’t set in stone. It appeared to us that Chinese investors were especially prone to falling for the “potent directors fallacy” (a term coined by Robert Prechter of EWI many years ago) – the belief that powerful decision makers, in this case the central bank and the government – would be willing and able support the market no matter what. Willing they have been – able, less so.
Chinese retail investors are shell-shocked
Photo credit: EPA
For a long time it has been the general impression that due to its tight control over the banking system and other sectors in the economy, China’s leadership could just “order the markets around”. Investors who were aware of China’s enormous debt problems and its insanely overvalued real estate markets were regularly baffled by the fact that China’s mandarins were apparently capable of arresting any decline in prices or any emerging credit blow-ups with the flick of a finger. Faith in their abilities is currently being shaken to its core. This is highly relevant to the asset bubbles currently underway in other countries, even though what happens in China has little direct effect due to the country’s closed capital account.
China’s stock market crash just keeps going – the index has now reached an important lateral support level. It will probably bounce from there, but for a variety of reasons this is actually somewhat less certain than it would otherwise be – click to enlarge.
The latest gambit of China’s central planners has been to replace the increasingly wobbly looking real estate bubble with a stock market bubble. The plan, as far as we can tell, was to enable state-owned companies to raise a lot of equity at favorable prices, so as to lessen the relative importance of their debt load, resp. enable them to deleverage by putting the proceeds of stock offerings toward paying down debt. However, the stock market bubble rested on an extremely shaky foundation: inexperienced retail investors and just as inexperienced fund managers were the main buyers, and they used plenty of margin to do so. Now they are in an unmitigated panic.
How to Shoot Oneself in the Foot
In their desperate effort to halt the decline in stock prices, China’s authorities have tried every trick in the book and then some. The latest gambit was initiated by listed companies, and may well have been the equivalent of shooting oneself in the foot: In order to stop stocks from declining further, many were simply suspended from trading. Some of those are suspended because they keep trading “limit down”, but in many cases the trading halts were requested by the companies themselves (the exchange must give its placet to such trading halt requests).
As a result, some 27% of listed companies are currently no longer trading, representing approx. $1.4 trillion in market cap. This is reminiscent of the futile attempts to halt stock market declines in the US and Europe by banning short sales in 2008 (as well as on other occasions, e.g. in early 1932, a short selling ban that was followed by a 69% plunge in stock prices).
“Chinese companies have found a guaranteed way to prevent investors from selling their shares: suspend trading.
Almost 200 stocks halted trading after the close on Monday, bringing the total number of suspensions to 745, or 26 percent of listed firms on mainland exchanges, according to data compiled by Bloomberg. Most of the halts are by companies listed in Shenzhen, which is dominated by smaller businesses.
The suspensions have locked up $1.4 trillion of shares, or 21 percent of China’s market capitalization, and are becoming increasingly popular as equity prices tumble. If not for the halts, a 28 percent plunge in the Shanghai Composite Index from its June 12 peak would probably be even deeper.
“Their main objective is to prevent share prices from slumping further amid a selling stampede,” said Chen Jiahe, a strategist at Cinda Securities Co.”
Later, the number of halts requested increased to more than 1,200, the 21st Century Business Herald said, citing exchange data. The Shenzhen Stock Exchange will reject unjustifiable applications for suspensions, QQ.com reported, citing an unidentified person familiar with the matter.
As an aside, the assertion that the stock market rout has “erased at least $3.2 trillion in value” as most financial media are reporting is a rather unfortunate way of putting it. What has changed are merely stock prices. In a way, the previous “values” were largely fictional. They reflected the fact that many in China felt they had discovered a get-rich-quick scheme and were piling in. The “wealth” this has created was phantom wealth – nothing has changed about the underlying businesses just because their stock prices have soared, nor has any money been destroyed because they plunged – it has merely changed hands.
Why are trading halts counterproductive? For one thing, as most of the suspensions concern small caps, investors are now trying to rescue themselves by selling big caps. For another thing, it deters new buying, because investors must fear that they will be locked out again from trading their shares at some point in the future – this has lowered the potential for a significant bounce. Also, while the decline has superficially slowed due to trading halts, the potential for an even bigger decline is now hanging over the market, as those holding suspended shares are likely to sell as soon as it is possible again.
Another effect was that the spillover to the Hong Kong Stock Exchange has worsened considerably. The HSI has crashed by almost 2,100 points or 8.37% overnight:
The HSI in Hong Kong begins to crash as well – click to enlarge.
Why Are the Authorities Helpless?
There is actually a good reason why China’s authorities have been unable to stop the crash so far, in spite of their otherwise well-known ability to influence markets and the economy. China is beginning to feel the lagged effect of the massive slowdown in money supply growth over recent years. This increasingly unmasks capital malinvestment in China and makes it more difficult to keep asset bubbles supported.
The year-on-year growth rates of the monetary aggregates M1 and M2 in China have collapsed to the lowest level in more than 15 years – click to enlarge.
China’s authorities are now finding out that one cannot have everything at once. If a credit bubble is to be deflated, asset prices cannot grow to the sky at the same time. Rising stock and real estate prices require “fuel” in the form of money supply inflation, and a slowdown in credit extension automatically brings about a slowdown in money supply growth in the modern-day fractionally reserved fiat money system.
As a result, even if the market should begin to bounce from here, it will very likely remain a “sell” until money supply growth has accelerated again for a while. This is however unlikely to happen anytime soon, as China’s banks are increasingly reluctant to add to their burgeoning credit problems (these don’t exist officially, but everybody knows they are simply masked by accounting tricks).
Prime minister Li Keqiang wants to reform China’s economy and is also unlikely to order banks to massively increase their lending again. He may of course eventually well be outvoted by others in the politburo, but at the moment, he remains in charge of economic policy. Note in this context that stock prices fell again on Monday after Li Keqiang failed to mention the stock market crisis in an official statement on the economy.
Conclusion
No bubble can remain aloft without a heavy dose of monetary inflation. The fact that China’s authorities, including its central bank, have been unable to stem the decline stands as a stark warning to the many Western investors who seemingly believe that central banks are nigh omnipotent entities run by magicians. This is not the case. Once an asset bubble begins to burst, there there is nothing central bankers can do to stop it – and we have plenty of bubbles awaiting their turn in the barrel.
China’s premier Li Keqiang: Apparently not sympathetic toward stock market speculators.
Photo via Wikimedia Commons
Charts by: BigCharts, St. Louis Federal Reserve Research
