China tries again to boost the stock market

Yesterday, after listing the several bad days in a row we have had on the local stock markets, I suggested that we would soon be testing 2000 again.  It happened sooner than I expected.  Today the market had another awful day, with the SSE Composite losing 3.0% to close the day at 2013, although at its low late in the morning the market actually traded well below 2000, to touch 1963.

Once again the regulators have responded by trying to force the market up.  Here is what the South China Morning Post says about it:

The China Securities Regulatory Commission has temporarily stopped reviewing applications for initial public offerings, sources said, a sign that Beijing is serious about bolstering the mainland’s embattled stock market.  The initial public offerings review committee of the CSRC had stopped processing applications between September 16 and the end of this month and the suspension was likely to be prolonged, the sources said.

The sources, who work at brokerages of investment banking units, said the CSRC did not officially inform them of the suspension.  However, they said the review process had been frozen as the regulator hoped to curb equity supply to the weak market.

I hate to repeat myself so often, but although preventing IPOs may indicate how serious Beijing is about the stock market decline, it is not going to have any real impact beyond further undermining the government’s credibility in bolstering the market.  After trying and failing so many times, every new attempt is likely to be taken less seriously by investors.  It would be better to hold back on administrative attempts to support the market and to wait until we really need a confidence booster – something which I suspect is going to happen soon enough.

This may be a smaller point, because I suspect there weren’t going to be many IPOs, anyway, but I wonder if restricting the ability of companies to raise equity (and last week’s new rules allowing companies to issue bonds and use the proceeds to repurchase stock) is a good idea.  More equity, not more leverage, will reduce the impact of the crisis if it spreads to China (and obviously enough to most of my blog readers I think it will).  This is a time for companies to be restructuring their balance sheets in the direction of greater conservatism, even if that comes at a high cost.  The more leverage there is out there, the more difficult the crisis is likely to be, and the greater the financial distress costs.  We should be moving in the opposite direction.

On a related issue Macquarie’s Paul Cavey has a very interesting research piece today on why China shouldn’t have cut interest rates.  He argues that the main source of China’s imbalances has been the mis-pricing of money via interest rate controls, and that this mis-pricing, coupled with China’s expansionary monetary policy, has led to misallocation of capital on a massive scale and unstable conditions within the financial system.  Cutting interest rates only exacerbates the problem.

This issue certainly hasn’t escaped attention in recent years. Calls for appreciation of the renminbi have clearly been loud. While often motivated more from a perception of US national interest, there have also been claims that appreciation would help China. The reason is the tremendous build-up of foreign exchange reserves that is the surest sign of undervaluation. To prevent exacerbating this inflow further, the authorities have kept interest rates low.

The combination is a classic recipe for a bubble. The liquidity creates the excess supply of credit, and the low rates the demand. Indeed, with nominal lending rates of now just 6.9% – the cost of capital – well below nominal GDP growth of 20% – the potential return – borrowing from banks isn’t just cheap for companies, it is a positive no brainer.

In reality, it is hard to find evidence of a credit bubble. Take bank lending growth of around 15% pa. Admittedly, this is a big number in absolute terms. But so are any of the figures that could be used to describe China’s economic growth. Thus, while growing quickly in absolute terms, the stock of outstanding credit has actually fallen relative to the size of the economy, from 125% of GDP in 2003 to around 100% now. This compares with the US, where in the same period credit has ballooned to almost 180% of GDP – and this does not even include the liabilities of the super-leveraged financial sector.

So, contrary to expectations of an unsustainable credit bubble, it looks like bank lending in China has been only just enough to grease the wheels of the rapidly growing economy. The reason is China’s banking sector has been effectively held in a straightjacket. The banks have been ordered not to lend, instructions which particularly this year has been backed up with sterilisation, the process by which the central bank uses reserve requirements and sales of central bank bills to soak up excess renminbi and stop the banks from lending.

Where I disagree with Paul is his implication that we have not seen a credit bubble.  I have written extensively about why I believe that strict credit loan constraints, and maybe even interest rate controls, are undermined (and necessarily so) in a system whose monetary policy is consistent with massive credit expansion.

The way I see it, in such a system credit controls are likely simply to push loan growth into less visible parts of the economy, and from what we have seen on the growth of off-balance-sheet transactions and from the anecdotal evidence about growth in the informal and underground banking sector, I would say that China has not been an exception.  If there were a good way to measure total credit in the economy, I don’t think we would see the decline over five years of total credit from 125% of GDP to 100% of GDP that Paul cites.  I think the problems he warns about have already happened – there has been a credit bubble and we are not sure what will happen when it deflates.

Originally published at China Financial Markets and reproduced here with the author’s permission.