China's stock market turmoil demonstrates in spectacular fashion the difficulties of disengaging from a command economy. What appeared to have started as an attempt to develop a strong stock market as an alternative to state bank financing has ended up digging the government even deeper into the unwanted roles of lender and buyer of last resort.
Indeed, China's currency devaluation yesterday and the reports of the coming issuance of 1 trillion yuan (S$222.8 billion) in infrastructure bonds by state banks were steps back to the country's old economic model. China needs a stronger currency if it wants to encourage consumption growth. A cheap yuan was - along with suppressed interest rates - one of the foundations of the export-led economic model, under which savers and consumers effectively subsidised the largely state-owned export sector. The plans to restoke the furnace of infrastructure spending complete the economic policy retreat - at least for now - from the so-called New China.
However, media headlines of recent weeks, warning that the stock market collapse heralds a deeper slowdown in the Chinese economy, have misread the nature of both the rally and the correction. The warnings were a day late and a dollar short. And they wrongly assume there is a "collective wisdom" about the economy in a market which had been driven by bureaucratic fiat. Equally misplaced is the fear that the sharp market correction might undermine further an already weakening economy.
Although the stock market is important in the government's reform plans, it is not big enough to inflict significant damage on the economy. Economic weakness - which had been in plain sight for around five years - will run its course. But it will have little to do with the fall in stock prices and everything to do with China's economic model.
CREATURE OF WEAKNESS
The rally in Chinese equities from the middle of last year was a creature of economic weakness rather than strength. It was the result of multiple interventions by the Chinese government to stimulate a slowing economy. But the government went further - it encouraged the stock market rally.
The rampant bull market from the middle of last year - which saw the Shanghai Composite Index rise 150 per cent - was the result of the convergence of monetary policy stimulus for the economy and administrative/regulatory measures which lifted sentiment towards the equities market.
The Chinese government, in rapid succession from the middle of last year, pumped liquidity into the banking system; slashed the benchmark lending rate, making money cheaper; cut the reserve requirement ratio for banks, enabling them to lend more; eased property financing rules; allowed retail investors multiple trading accounts; announced mega infrastructure development plans; swapped debt held on the central bank's balance sheet into equity; and converted local government debt into municipal bonds. All the while, the state media talked up the stock market.
Economic growth had slowed from almost 12 per cent in the first quarter of 2010 to 7.5 per cent in the middle of last year. China's investment and credit intensive economic model was running out of puff. But it was not that China was over-invested. China's capital stock per worker ratio was still less than one-tenth that for the United States. Rather, capital had not been allocated efficiently. The allocation was conducted by state banks to mostly state-owned enterprises and local government vehicles - often for inefficient or unviable projects. The inefficiency of the lending shows up in the rapid increases in investment and credit required to churn out each unit of gross domestic product (GDP) growth. In 2005, it took around 1.5 yuan of credit to generate 1 yuan of GDP. In less than a decade, it had surged to 4.5 yuan to generate each yuan of economic activity.
If left unchecked, this will eventually land China in a debt crisis. Indeed, China's total debt (government and private) had risen to an uncomfortable 280 per cent of GDP, not too far from the 330 per cent in the US.
So a strong stock market can be useful in generating private consumption growth through the "wealth effect", at a time when investment growth is slowing sharply. A strong equities market will also be useful for raising capital in what is likely to be a lengthy deleveraging exercise for the economy. Private capital is also helpful in taking the burden of funding investment projects away from state- owned banks. To begin with, privately funded and managed projects are more likely to be financially viable than state-funded and managed ones. And in any event, if they fail, the losses will be on private rather than state books.
All of which explains why the Chinese government had been so supportive of the stock market in its run-up and why it had thrown so much of the financial and regulatory resources of the command economy at the market during its recent turmoil. The problem was that the government had used the tools of the command economy to transition away from the command economy. Leaving aside the state's financial muscle being used to support the market, the most stunning - and this is not intended as praise - aspects of the recent government interventions were the suspension of half the market and the ban on significant shareholders selling their stocks. The government stabilised the market by denying the market.
And now, the Chinese investing community might think the so-called "Bernanke Put" of the US, circa 2009-2014, has travelled to China, reincarnated as the "Beijing Put". So we have come full circle. An attempt to move the economy away from dependence on the resources of the state has now ensnared the government into committing the resources of the state to supporting what should have been a private endeavour.
DIFFICULTIES OF DISENGAGING
Stabilisation has been achieved. But normalisation will take much longer. Meanwhile, those expecting a quick recovery in the Shanghai Composite Index back above 5,000 points will likely be disappointed. It is in the interest of the government to prevent a disorderly collapse of the market - not least because its political stock is also at stake. But it is not in the interest of the government to see a rapid return of mania.
Indeed, commentators disappointed with a renewed sell-off after the initial rebound of 3,370 points probably missed the fact that the market had rebounded 24 per cent in less than two weeks.
At that rate, it would have been back above 5,000 points after another two weeks - with Beijing expected to act as buyer of last resort if things go awry. Chinese policymakers won't want that. So the market will likely be in for a long grind back to its prior high.
But that said, little damage will be done to the economy as a result of the market's weakness. Estimates of household participation in the stock market range from 10 to 15 per cent. This is roughly comparable to the 13 per cent in the US.
Meanwhile, the Shanghai Composite Index - notwithstanding recent falls - is still more than 80 per cent higher than where it was in the middle of last year. Margin debt, at its recent peak, was about 3.6 per cent of GDP - not terribly far from total margin debt on the New York Stock Exchange, which stood at around 2.6 per cent of the US GDP at the start of this year.
Anyway, the figure for China has since declined to only 2.1 per cent of GDP now. Margin loans provided by banks and stock brokers are estimated at between 1 per cent and 2 per cent of the banks' combined loan book. Add to that the "margin" or buffer to protect lenders, there is no systemic risk here.
The problem is not how China's stock market weakness affects its economy. The problem is what the government's involvement says about the difficulties of disengaging from the command economy - as do the plans to raise 1 trillion yuan for infrastructure spending and the devaluation of the yuan yesterday.
To be fair, these moves may be part of a "two-steps forward, one-step back" strategy to restructure without imploding the economy. That is, if the economy slows too much, there is a risk of hitting an unknown "stall speed", at which economic slowdown meets bad debts in a downward spiral, with all its dangers of social unrest. So reforms will most probably still continue but clearly China's policymakers have blinked.
The problem is what the government's involvement says about how China is managed. In a different world, in a different context, in a different time, the late John F. Kennedy famously said that those who rode the back of the tiger often ended up "inside". This is China's dilemma as it seeks to get off the back of the command economy.
The writer, a former financial journalist in Australia and Singapore including with The Straits Times, is now chief investment officer at DBS' Consumer Banking Group & Wealth Management.
This article was first published on Aug 12, 2015.
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