China – the world’s
biggest economy in terms of purchasing power parity and the world’s second
largest economy in nominal terms - is going through some serious economic
turbulence. Challenging macroeconomic environment, slowing rate of growth and
the freefall of Chinese stock market reveal some serious concerns about the
viability of the policies adopted by Chinese policymakers over the years to
fuel their growth.
What
went wrong in China?
The recent boom, bust
and the prevailing uncertainty in the Chinese stock market shows how the policy
makers can influence, perturb and manipulate the financial system and can
create serious repercussions around the globe. The Chinese stock market had
witnessed one of the biggest stock market rally (I would rather use the word
frenzy) in the history with the Chinese stocks returning more than 150 percent
over the last year. The main catalyst for this rally was Margin lending which
means borrowing to invest. Margin lending is present in almost every financial
system, but what made Chinese stock market unique in this case was the type of
investors participating in this borrow and trade fury. Usually margin trading
performed by highly experienced institutional investors who deal with millions
of money and with almost all the available information access. But in China it
was the retail investor’s cup of tea. The vulnerability of the Chinese stock
market is best described by Scott Kennedy of the Center for Strategic and
International Studies by saying that, “Over a quarter of China's stock market
capitalization is now supported through margin financing, turning an equity
market into a de facto debt market.”
The forces which directly
or indirectly caused this margin lending spree are
1)
Fuelling the growth after the 2008 financial meltdown using fiscal and monetary
stimulus
The 2008 global financial meltdown witnessed a renewed interest in Keynesian economic ideas. In order to revive the demand and put their economy back on track, governments and central banks across the world started to pump in money heavily through fiscal and monetary stimulus. China also was not an exception. Years of interest rate cuts and fiscal stimulus packages created a lot of money in the system. The pumped money has to go somewhere in the system and eventually a lot of money went into the stock market.
 |
Source –
Trading Economics
|
2)
Government’s role in promoting margin lending - China
Securities Regulatory Commission (CSRC) allowed people to invest in equities
through margin lending route from October 2011 after conducting a pilot program
in March 2010. Down the line the government relaxed the rules of margin lending
to promote retail participation in the stock market and millions of money
pumped into the stock market through brokers and retail investors. The number
of retail participants in the market increased from 82.66 million in
08-may-2015 to 92.357 million by 24-july-2015. An interesting fact is that
nearly two third of people who involved in margin trading (which required a lot
of experience and insights) did not complete even the high school degree. As
more people took part in this stock buying frenzy, Between June 2014 and June
2015, the amount of officially sanctioned margin trading in the Chinese stock
market ballooned from 403 billion yuan to 2.2 trillion yuan.
 |
Source -
Bloomberg
|
Unlike foreign exchange
markets where central banks frequently intervene, the governments strive not to
intervene in the stock markets since intervention transmit negative signals and
carry market-related side effects.
But when the Chinese
market went into a freefall, government announced several measures including
interest rate cuts, capping short selling, relaxed rules which allow pension
funds and social security funds to invest more in stocks, and allowed people to
use their houses as a collateral to borrow money to buy stocks. Most
significantly, it used a state-owned securities financing company to lend $42
billion to 21 brokerages so that they could purchase blue-chip stocks.
Government was trying
their best to control the market. Why?
The
Intervention of government in the stock market to restore the equilibrium
There were two reasons
that can be attributed to the government intervention in the market. One is
being the sociopolitical considerations and another is being the economic
considerations.
Sociopolitical
considerations – over the past years, the majority of
people who invested in the Chinese market are predominantly retail investors.
The various policies taken by the government send a strong signal that in case
of any serious downturn, government will come to their rescue. So if investors lose
money, it can create a lot serious disturbances in the socio political arena.
As a result government has no alternate option, but to intervene in the market.
Economic
considerations - Chinese economy is going through a
challenging phase. As per the IMF, the growth rate is expected at 6.3 percent
in FY16 which is way below the average growth rate of 9.04 percent achieved
during the period 1989 to 2015. So Government had to showcase the stability of
the financial system or else it can send serious negative sentiments around the
globe which may deteriorate the current macro environment situation further.
Why
should we care?
Globalization and
technological advancement acted as a reason to expand the breadth and depth of
the financial markets and allowed them to work in a highly interconnected mode.
The main fallacy of this is that even a small disruption in one market can send
very serious repercussions across the globe.
Consider the following
graph that shows the movement of CNX Nifty and SSE Composite index from
01-June-2015 to 31-July-2015.
One thing which can be
observed from this graph is that the Indian market was highly volatile during
this period and a significant part can be attributed to the issues in china.
The average Volatility index (VIX) for this period was 16.34 which was greater
than the 30 days and 200 days moving average of 15.88 and 16.20 respectively.
What
Policymakers have to do?
The Chinese problem is
not the only example of the preposterous policies taken by the government
focusing only on the short term rewards and benefits. We have observed many of
these kinds of policies in the past. 1997 Asian financial crisis to the US
subprime mortgage crisis to the current euro zone crisis has something to say
regarding this. Many can argue that the size of the China's stock market is not
as big, relative to the Chinese economy. So the economic implications are not
that systemic in nature. But that is not an excuse for policy makers in taking
imprudent decisions.
So what we need in the
long run is a rule based predictable and sustainable monetary and financial
arrangements. But unfortunately policy makers across the globe haven’t done
enough thinking on that and the current monetary policy practices focus mainly
on the short term benefits. As a result it exposes substantial risk to the
global economy. As the honorable governor of the RBI, Raghuram Rajan pointed
out in his speech at the Economic Club of New York; “we are being pushed
towards competitive monetary easing. But what we need are stronger,
well-capitalized multilateral institutions with widespread legitimacy. In order
to build such institutions we need global co-operation and participation from
the policy makers. Only by creating these types of institutions we can absorb
the possible future and a stable and create a predictable financial system.”
Regards,
Harikrishnan
Views are personal :)
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