Market temporarily breaks below 2500

The Chinese stock markets declined further today, with the SSE Composite punching its way through the psychologically important 2300 in the first hour of the day, to trade as low as 2248 in the later afternoon (with 2500 often cited as another important “barrier”, below which the government was presumed to intervene) for a total loss of 2.5%.  It recovered part of its losses in the last hour of trading to close at 2278, down 1.2% for the day.


This should have been a big event but most participants seem pretty inured to bad news by now.  Given the gloom I continue to wonder if we might not be close to a bottom in the stock market.


On a separate front I think my pessimism about the financial system is being matched, if not exceeded, by others.  Andy Xie, who has been one of the savviest of commentators on China, has another warning piece in Caijing, probably the most open and hard hitting of local periodicals.  Among other things Xie writes:


There is obviously a liquidity problem in China’s economy. Triangular debts, especially in the form of receivables, are piling up. Lack of money at local government level may be the root cause. Local governments are quite dependent on land sales and taxes in the property sector to fund their expenditure. That dependence motivates them to spice up the property market, which is a major reason for the bubble.


At a deeper level, the declining share of fiscal revenue for local governments in the past ten years has motivated local governments to search for new revenue sources, which eventually ended in the property market. The massive land sales last year at record prices may not bring the promised cash for local governments. The property bubble has burst. Developers cannot sell properties like before and can’t keep their promises of paying for last year’s land purchases.  Slowing property sales also decrease their taxes. The cash-short local governments cannot pay their contractors that in turn can’t pay their suppliers.


This is the second time I have heard him warning about “triangular debts” among Chinese companies.  I haven’t been following the issue closely except to note that inter-company loans have risen rapidly, and represent yet another way in which lending caps imposed on the banking system have been undermined.  They also create a worrying mechanism for credit and liquidity problems to spread from one company to others.


Xie adds: “China’s financial system, in particular, is a heavy burden on the economy.”  He goes on to say:


You might find my assertion strange. Chinese banks are among the largest banks in the world in terms of bank capitalisation and profits. Chinese brokers made big profits last year, although they are down this year in a slumping market. If profitability is the best guidance for efficiency, China’s financial system should be the most efficient. The problem is that China’s financial institutions have made profits from licensed monopolies and government-regulated interest rates. As credit is rationed and, hence, is in short supply and government mandates interest rates, Chinese banks can make fat profits from their credit quotas. Their profits don’t reflect their efficiency. Rather, their profits are a tax on the economy.

China’s securities industry is more ridiculous. Stock market is the most capitalist market.  Securities firms that service the stock market should be the most capitalist too.  In China, securities firms are mostly state-owned.  It is impossible to find an example of a successful state-owned securities company in the world.  It is surprising that China doesn’t see the problem in its approach.

The inefficiency of China’s financial system is a huge cost for the economy. My guesstimate is that the burden could be five percent of the GDP, i.e., China’s financial sector has negative value added of five percent on the economy. Addressing the inefficiency in the sector could be a significant stimulus for the economy. China should start by raising deposit rates to narrow the lending spreads to a normal two percentage points. Of course, the central bank should likewise lower the deposit reserve ratio in order to normalise the banking system. The outflow of hot money provides a good environment for cutting the ratio.

China’s stock market is a big failure. The Shanghai A-shares index surged from 1,000 to 6,000 in two years and then dropped to 2,400 in one year. You can’t blame people for thinking that China’s is a Mickey Mouse market. China should completely revamp its market to prevent future crisis like this one. The most important change should be to disentangle the government from micro interventions in the market. When laws are laid down, the market should function on its own. It is the only way to have a healthy market.

On a separate note Xinxin Li at the Observatory Group writes in a September 2 about changes in the financial leadership.  According to him, “a looming personnel change in the PBOC could provide important guidance about the outlook for monetary policy beyond the short‐term.  Vice Governor Yi Gang, who is in charge of monetary policy in the PBoC, is likely to become the new chief of the National Statistics Bureau in a few weeks.  If his successor comes from the pro-growth camp, that may indicate an important shift in Beijing’s monetary policy.”


There have been tons of rumors for quite a while about leadership changes at the PBoC and the banks.  I have referred broadly to these several times in my blog but am wary of being too concrete.  I don’t want to get into trouble.  If as Xinxin suggests Vice governor Yi becomes the head of the Statistics Bureau, that might indicate a strengthening of the monetary camp since Yi is well-known to be tough on monetary issues, but truth is not that obvious.  The key questions are about who will replace him and whether there will be other even more senior changes in the PBoC.  Many of us (including me) are expecting imminent changes in leadership within the financial system that will result in a stronger voice for the pro-growth camp.  I think analysts are watching this more closely than any other issue right now.


To close on a related bit of good news, yesterday the National Bureau of Statistics published a report in China information news that suggested that thanks to declining food and oil prices CPI inflation would ease further in August and September.  That is certainly what the bond market seems to think.  According to Credit Suisse in today’s Emerging Markets Economic Daily one-year treasury yields are currently at 3.31%, down 23 basis points from the beginning of August.


Clearly this news will embolden the pro-growth camp to push for greater fiscal and monetary stimulation.  At first glance this ight even be showing up in the exchange rate policy.  Recently the pace of appreciation of the RMB has declined – it even depreciated quite sharply during the first two weeks of August.


Logan Wright, however, in his August 25 Stone & McCarthy research piece, argues that while many analysts interpret this slowing appreciation as an indication that the PBoC is targeting not just the US dollar but a basket of currencies in its overall appreciation strategy (the dollar rose against the euro for much of this period, bringing the RMB up on a trade-weighted basis), he disagrees.  He argues instead that this is just political interference aimed at dissuading investors from believing that the RMB is a simple one-way bet.


The goal is, presumably, to introduce enough uncertainty to discourage speculators from flooding the domestic monetary system with foreign currency inflows.  I agree with Logan’s interpretation.  In expect that after some period the RMB will resume its upward march against the dollar.  As I suggested nearly 18 months ago, China needs to revalue its currency sharply to regain control of its monetary policy, but a gradual rapid appreciation would inevitably undermine that goal by encouraging massive capital inflows.  This is what seems to have happened.