As everyone by now knows, a massive intervention last Thursday by the Fed and the US Treasury, which the Financial Times calls “the most extensive peacetime expansion of the role of government in the financial system since the Great Depression,” and seemingly coordinated world-wide, caused a huge rally in global stock markets. Chinese markets were no exception.
Thursday night, the night before the intervention, the government had independently signaled its own worries about the markets by dropping the 0.1% stamp duty on stock purchases (the duty remains on stock sales) and announcing to the media that Central Huijin, an arm of the CIC, would buy shares in three of the Big Four banks (all except Agricultural Bank, which has not yet had its IPO). Why only banks, if the goal was to support the broad market? Perhaps in part because banks are a large part of the index and because the mechanism (Central Huijin) was already in place, but I suspect that at least part of the reason had to do with concerns about the self-reinforcing positive feedback loop between stock prices and perception of creditworthiness that was such an important part of the banking crisis story in the US.
I don’t think the reduction in stamp tax had much impact, but coming as it did with the stock purchase plan and the huge global rally, China’s stock markets flew on Friday. The SSE Composite immediately shot up on opening, wobbled a bit for a few minutes, and then recovered so that within the first 30 minutes it was up 9.5%, to trade flat the rest of the day, closing at 2075. For those wondering why it traded so flat for most of the day, remember that the Chinese markets have a 10% rule, which causes trading to stop when a stock is up or down by 10% within the trading day. Normally, when the market trades at its limit for most of the day, the momentum is carried forward onto the next day.
Will it maintain the momentum beyond a few days? I doubt it. If Chinese share had declined because of liquidity issues affecting the US and global markets, I would argue that the various interventions might be enough to resolve what was, after all, “just” a technical liquidity problem. However because of fairly strict capital and investment restrictions there is very little connection between China’s financial markets and global financial markets, so it seems to me that nothing fundamentally has changed. In addition I don’t think the full extent of the international crisis has yet hit China – there are transmission lags in both the capital account and in real economic links – and so we are likely to see more problems before the crisis is safely behind us.
At any rate my Peking University graduate student Shang Ning, being very curious, immediately decided to see what has typically happened when the Shanghai market has moved up by 8% or more in one day. He found five cases during the decade, two of them this year, and emailed his findings to me. His numbers suggest that sharp upward movements are no more likely to presage future gains than to presage future reversals:
This table proves nothing, of course, except that big upward price movements are not as rare as we might expect, and that in the past they have not been particularly good at predicting the future, but they do show how noisy very speculative markets are. The only bullish indicator I can find is that from what I gather most analysts and fund managers are warning that the price rally is not likely to be sustained.
For all the fear and panic abroad, and the attendant urge to regulate markets more strictly, it is refreshing and a hopeful sign that in China, in appearance at least, the regulators are still determined to liberalize the financial markets. According to an article in Friday’s People’s Daily, a number of regulators were pretty clear about this in a forum held in Beijing:
Undaunted by the worsening US financial crisis, partly blamed on regulatory shortcomings, Chinese regulators are pushing for more reform and speedy development of the nation’s financial sector. “It is time to lift excessive regulatory restrictions on private sector financing, which could help boost the dynamics of enterprises as well as improve the capital efficiency of the financial industry as a whole,” said Wu Xiaoling, vice-chairwoman of the Financial and Economic Committee of the National People’s Congress, at a financial forum in Beijing yesterday.
Wu said encouraging private companies to raise money directly from investors could also help reduce pressure on the government to relax its monetary policy, which is central to the fight against inflation.
The problems facing the Chinese financial system are very different than the problems facing the US, and Fan Gang, director of the National Economic Research Institute, made the distinction very explicit at the forum:
“Much of the problem behind the US financial crisis stemmed from the excessive complexity of financial derivatives,” Fan said. But China is facing challenges of an entirely different nature, he said. “The Chinese financial market, still at the initial stage of development, lacks effective financial tools, which has hampered the sustainable development of the market,” he said.
Fan called on decision-makers to further relax regulations to assist development of a multi-layered financial market. “An overly tight regulatory system would not minimize risk, but would instead force us to passively shoulder the risks passed on from foreign markets,” Fan said.
Talking about reform in the banking sector, Fan also noted that the interest rate should be dictated by market forces to promote competition that could lead to innovation. “We should make greater efforts to let market forces dictate the capital costs and introduce competition to China’s commercial banks in the hope of strengthening their capacity to withstand risks in the global market.”
Regular readers of my blog know that I have not been overly impressed either by the pace of financial reform or by policy-makers’ understanding of balance sheet risks, and my first instinct was to assume that the global financial crisis would result in reform paralysis. Just as, I think, a lot of policy-makers misread the lesson of the 1997 Asian crisis and put into place a Maginot Line of defense that actually increased the risk of domestic imbalances, I was worried that one misreading of the current crisis is that financial power should be even more concentrated in a few large banks under direct control of the regulators. But perhaps not. It seems, at least as far as the forum went, that many of China’s most influential regulators don’t think so.
For all the surface calm it is pretty clear that an awful lot of policy-makers are very, very worried. In the property market one gets a sense of deepening gloom. Saturday’s South China Morning Post had an article describing a funding concern that property developers are increasingly facing:
The mainland property market is expected to face an estimated capital shortfall of 673 billion yuan (HK$765.94 billion) this year as tighter controls on bank loans accelerate consolidation. Beijing Normal University said in a research report on capital financing in the real estate industry that falling liquidity and weakening demand for housing deepened the industry’s predicament in the middle of this year.
It predicted the capital gap would narrow to 492.5 billion yuan if there was a significant turnaround in the property market by the end of next year. But the report warned that the shortfall would widen to 929 billion yuan if the market correction extended beyond next year.
With credit markets now effectively closed to property companies, yesterday’s land auction in Shanghai garnered a poor response. Three of the six sites put up for auction failed to draw any bids, which meant they would be withdrawn from sale, according to the Shanghai Municipal Housing, Land and Resources Administration Bureau.
Real estate, as everyone knows, is one of the Achilles’ heels of the financial sector and the one most likely, in most analysts’ opinions, to lead to a banking contraction. My pessimism about financial sector strength in China is well-known enough to readers of my blog that they won’t be surprised to read that I believe there to be many others – overcapacity in the industrial sector leading to a sharp rise in inventory, sudden hot money outflows causing a shrinking in formal and informal bank funding, a renewal of inflation, rapidly declining corporate profitability, and slowing retail and export growth, to name a few (I am mangling my Achilles’ heel metaphor, I guess).
One consequence of the recent crisis is that it should put to sleep one of the most enduring myths of recent years – that financial crisis are largely currency crises. In fact most are not, and the determination of many countries, including China, to engineer policies that reduce the risk of a currency crisis has had the paradoxical effect of actually increasing domestic imbalances and so increasing balance sheet vulnerability to crisis. I think Russia’s example should be enough to destroy the idea that current account surpluses, limited external debt, and large reserves are a sufficient safeguard, especially if there has been rapid growth in the banking system.
To that end there is an excellent article Open in a new window in last Wednesday’s Financial Times that discusses why. It starts out:
On paper, Russia’s economy looks to be virtually bullet-proof. With a 7.5 per cent year-on-year growth rate in the second quarter, it has the third largest foreign exchange reserves in the world, low international debt, a huge resource-fuelled trade surplus and nearly $200bn (€141bn, £112bn) stashed away in sovereign wealth funds.
Seen from the markets, however, the situation looks anything but rosy. Stock market indices stand at less than half their May peak, billions of dollars of foreign capital has quit the country and credit has all but dried up. Efforts by the central bank to inject liquidity are having little effect. “What is happening is that no one is lending to each other,” says Garegin Tosunyan, head of the Association of Russian Banks. “This is not so much a financial crisis as a crisis of trust.”
With world markets plunging, Russia’s financial sector has been one of the hardest hit by contagion from the US credit squeeze. On Moscow’s stock exchanges and banks, global conditions have exacerbated an existing crisis whose origin was largely domestic, emerging during the Russia-Georgia war in August.
Yes, yes, I know: Russia is not China. There are lots of differences between the two, including rules on capital transfers, but the point is not to say that China and Russia are vulnerable in exactly the same way but rather that the argument that high reserves, large current account surpluses, and low external debt are proofs against crisis is simply not true. If anyone wants to suggest that China is safe from financial instability he will need a much more sophisticated argument than that.
This entry is getting even longer than usual so I will make two other quick points before ending. First, I didn’t think the explosive milk scandal in China had much relevance to my blog until my friend Victor Shih made one of those comments that immediately make sense. He wondered why the use of melamine seemed to have started so abruptly and spread so quickly. It would have been more natural, if it was simply a “normal” case of unscrupulous manufacturers, for the contamination to have developed more slowly. One possibility, he argues, is that the deterioration in quality is a not-unexpected outcome of recent price controls. As the cost of inputs rose faster than the price at which retailers were allowed to sell, there was more pressure than ever for manufacturers to cut costs and engage in risky behavior.
I don’t know if this is true or not, although it sounds perfectly plausible, but since I read Victor’s comment I have seen that the idea – that there may be a connection between the imposition of price controls and the rapid expansion of the use of melamine – has become very widely discussed. Traditionally price controls often lead to shortages and to cuts in quality, and perhaps the milk scandal is one of the unexpected costs in using administrative measures to fight inflation.
The second point I want to close with is a happier one. Today’s Bloomberg says Open in a new windowthat “China, the world’s biggest consumer of grain, may harvest a record output this year after farmers seeded more land with rice, corn and soybeans, the Ministry of Agriculture said.” If food production grows sharply, it will limit the risk of another surge in food inflation. I do not know enough about agricultural production and food consumption to say whether the record output is enough to keep up with demand, but it’s a start.
Originally published at China Financial Markets and reproduced here with the author’s permission.