I finally got back to Beijing on Monday, but after an interesting lunch with a group of pessimistic Brazilian hedge fund managers who were concerned about financial fragility in China and its impact on Brazilian markets, I had to fly that afternoon to Hong Kong for two days of meetings. It is not a lot of fun traveling in a period like this, especially when people are asking your advice on market events, because whenever you are away from the screens for more than an hour or so it seems that another earth shattering event has taken place that makes all of your comments immediately out of date.
Not surprisingly, the Chinese stock markets did very badly this week. Monday was a holiday, but when the market opened Tuesday the SSE composite quickly lost 4.4%, and dropped a further 2.3% on Wednesday and 1.7% today to close at 1898. Clearly 2000 was not the bottom. In an effort to stop the decline the authorities announced today that effective Friday they will cancel altogether the stamp tax on stock buying.
Big deal. They have tried so often to signal the market up or down that I am pretty sure that they have little credibility left, and so I suspect that this cancellation will have absolutely no effect. Real news – either domestic or from abroad – is going to drive the market tomorrow.
Unlike in the rest of the world the local media seems to have been fairly muted in reporting the developing financial crisis. For example there seem to be more visible headlines in the People’s Daily and in Xinhua about the successful end of the Paralympics and of the tainted milk scandal than about the global financial crisis, much of which reporting was relegated to the business sections. I suspect that the authorities are worried about the impact of the rising gloom on retail spending, as perhaps they should be. Rising consumer demand was one of the few bright spots in recent economic data releases, and although I suspect that the Olympics had a lot to do with that, it won’t pay to scare Chinese consumers into saving more in reaction to the growing global uncertainty.
Actually a lot of journalists have been asking me today about the impact of the stock market on consumption and confidence. I don’t think there is likely to be a very strong direct impact since in China the stock market is still very small relative to overall GDP, but of course watching the market fall so quickly is likely to have an adverse psychological impact on consumer spending, and maybe a large one. More important, I think, is the property market. Chinese consumers, banks and corporates are far more heavily invested in real estate than in stocks, and it is here that declining prices can really impact the economy. Unfortunately I don’t think is a very good story either
For example yesterday’s South China Morning Post had a massive front page headline in its Property section: “Price war fails to lift mainland sales”. The article starts off with:
Mainland property developers have resorted to steep price discounting to lure buyers back to the market this month and next, the traditional peak home-buying season.
“It is the first time we have seen a price war happening in all the major mainland cities. Almost all projects in Beijing have now cut their asking prices,” said Li Wenjie, the general manager of Centaline (China) in Beijing. However, the tactic has so far shown no sign of reversing the decline in property sales and analysts do not expect lower prices alone will be enough to restore buyer confidence.
The authors follow up today with another article entitled “Sweeteners may leave potential buyers with bad taste in their mouth.” As long as property prices were rising, the trend was reinforced by buyers who, expecting continued rising prices, rushed in to accelerate their purchases or even bought for speculative purposes. Now, however, according to the authors, declining prices are having the opposite effect. Even people who want apartments or offices, and even if they find current prices acceptable, are holding off on purchases because of concerns that prices will soon be lower. Speculative buying, of course, is likely to be negative. These are the kinds of self-reinforcing tendencies typical in booms and busts that guarantee volatility. There are many more in China.
One impact of the crisis is to worry more about sources of volatility. According to an article in today’s Bloomberg,
China’s government may thwart new financial products including derivatives to avoid the subprime crisis that’s wrecked havoc on the U.S. credit market, said the Chinese bank regulator’s deputy research chief. The regulator will instead improve risk-management practices and force banks to put checks in place to prevent Asia’s second-biggest capital market from being roiled, said the China Banking Regulatory Commission’s deputy research chief Fan Wenzhong.
“The subprime crisis is far from over, so China’s regulator should enhance risk awareness and protection,” putting the emphasis on ensuring financial stability rather than innovation, Fan said today at a conference in Beijing. The point of China’s financial reforms is “not speed, it’s about stability,” he said.
I have always thought China’s markets were far too speculative for the introduction of derivatives, which were likely to be used largely to multiply the force of speculative buying and selling, so exacerbating market volatility. I am glad they are more reluctant then ever to move this forward.
Derivatives can improve the efficiency of markets, but they cannot create an efficient and stable market. It is only the existence of a diverse investor base, with plenty of fundamental and relative value investors, as well as of course of some speculators, that can create a market that allocates capital efficiently. In order for China to have such an investor base it is far more important that investors have better financial and economic information and a mechanism to enforce discipline on managers than the shiny but dangerous derivative toys, which can exacerbate self-reinforcing behavior.
Still, it is important that regulators not draw the wrong conclusions. The US financial crisis was not caused by too free markets or too little regulation (or even by high bonuses and complex securitizations). We have had very similar financial crises for thousands of years without any of these things. In fact one of the “obvious” solutions to this year’s crisis – force unstable investment banks to become part of stable commercial banks – is exactly the opposite of the solution proposed for the 1929-31 crisis – separate commercial banks from investment banks. Clearly our analytic framework leaves something to be desired if these two very opposite solutions can be proposed for the same problem.
In my humble opinion the problem is not (and never is) the specific circumstances of the crisis. The problem is very different. Hyman Minsky has already argued extensively (and conclusively, in my opinion) that there is no such thing as a permanently stable financial system. You can read a decent summary of his thought on crises here.
According to Minsky any attempt to remove or regulate away volatility or risk automatically changes the behavior of financial institutions so that they engage in greater risk-taking behavior (among other things, in a lower-risk environment, institutions and individuals that take “too much” risk will grow at the expense of prudent and risk averse players), until at some point the system is as risky as it ever was. The sound bite for his Financial Instability Hypothesis was “financial stability is destabilizing.”
Minsky focused very much on tendencies within balance sheets and the institutional structure towards automatic destabilizers (what I usually call self-reinforcing tendencies), and argued that rather than eliminate crises we should minimize these self-reinforcing tendencies and their economic impacts. “We can, so to speak, stabilize instability,” he wrote, by creating automatic fiscal and monetary stabilizers that counteract expansion and contractions in the financial system.
I have been a hard-core Minskyite since the early 1990s (he was a big influence on my own understanding of financial crises) and it is for this reason that I have harped on so long in my blog and in the press about the weaknesses in Chinese balance sheets, which include so many automatic destabilizers (the South China Morning Post articles cited above describe exactly one such process).
So if it wasn’t evil or stupid bankers playing with toxic toys that “caused” the current crisis, what was the real problem? In my book on the last 200 hundred years of capital flows from rich to poor countries (which is, not coincidentally, also the history of the last 200 years of financial crisis), I argue that periods of rapid monetary expansion preceded every financial crisis – and these crises, although they seemed to have occurred for a plethora of different “reasons”, all looked practically the same.
This is not a coincidence. Excess money increases risk appetite and forces financial institutions into riskier behavior. At first, riskier behavior is highly rewarding because as risk premia decline, institutions that took the most risk benefit most, and prudent institutions go out of business. But as companies, banks, and households build increasingly risky balance sheets it takes a smaller and smaller shock to cause a rapid unwind. To understand how destructive the subsequent “unwind” will be we need to get a sense of how strong the self-reinforcing processes are and whether regulators, the government or other institutions have automatic stabilizers in place.
It is excess monetary expansion, in other words, that leads to overextended financial systems, leveraged balance sheets, and destabilizing tendencies. If this is correct, what does that say about China’s susceptibility to the global economic crisis? Well, regular readers know that I think there has been way too rapid money growth in China.