Source: China Financial Markets
Anyone who reads my blog is already likely to know the story. Until the market peaked on June 12, with the Shanghai Composite at 5,178, China had experienced a stock market boom that saw the Shanghai index rising in what seemed like a straight line by more than 135% in one year. The boom seemed almost inexplicable from a fundamental point of view. The market soared as growth expectations for the Chinese economy fell, corporate profitability was squeezed, and banks, who dominate the index, saw a sharp rise in NPLs. What’s more, during this period it was increasingly clear that China’s declining GDP growth was still overly reliant on excessively rapid credit growth, and that to get control of the latter the former would have to drop a lot more.
Although the market peaked in mid-June, the panic really began some time in the first week of July (July 7 is now being referred to by some as China’s “Black Tuesday”), by which time, however, the market had already lost nearly one third of its value. Since late June Beijing had implemented a series of measures to stop the decline, none of which had the desired effect, and by the weekend of July 4-5 there was a sense of complete desperation as the regulators reached for wholly unprecedented attempts to control the fall.
The stock market panic seems to have ended on July 9, when the Shanghai markets closed up 5.8% on the day, followed by strong gains the following Friday and Monday, but Tuesday’s 3.0% decline set hearts fluttering again, and the nervousness did not abate over the next three days as stocks continue to rise, but not without drama. For now I think we can safely say the panic is finally over, but none of the fundamental questions have been resolved and I expect continued volatility. Because I also think the market remains overvalued, however, I have little doubt that we will see at least one more very nasty bear market.Either way the panic and the policy responses have opened up a ferocious debate on China’s economic reforms and Beijing’s ability to bear the costs of the economic adjustment. Among these costs are volatility. Rebalancing the economy and withdrawing state control over certain aspects of the economy, especially its financial system, will reduce Beijing’s ability to manage the economy smoothly over the short term but it may be necessary in order to prevent a very dangerous surge in volatility over the longer term.
Sunday’s Financial Times included an article with the following:
Critics of the measures unleashed by Beijing last week argue that they point to a fundamental tension at the heart of China’s political economy that a free-floating renminbi would test even more severely. The ruling Chinese Communist party, they argue, is ultimately incapable of surrendering control of crucial facets of the country’s economic and financial system. As one person close to policymakers in Beijing puts it: “The problem with this system is that it cannot tolerate volatility and markets are all about volatility.”
It’s not just that markets are about volatility. It is that volatility can never be eliminated. Volatility in one variable can be suppressed, but only by increasing volatility in another variable or by suppressing it temporarily in exchange for a more disruptive adjustment at some point in the future. When it comes to monetary volatility, for example, whether it is exchange rate volatility or interest rate and money supply volatility, central banks can famously choose to control the former in exchange for greater volatility in the latter, or to control the latter in exchange for greater volatility in the former.
Regulators can never choose how much volatility they will permit, in other words. At best, they might choose the form of volatility they least prefer, and try to control it, but this is almost always a political choice and not an economic one. It is about deciding which economic group will bear the cost of volatility.
But one way or another there will be an enormous amount of volatility within the Chinese economy, not just because it is a relatively poor developing country, which have always been more volatile economically than advanced countries, but also because it is so highly dependent on investment to generate growth. Hyman Minsky argued that economies driven by investment are extremely volatile and overly susceptible to changes in sentiment, and he is almost certainly right.
During the market panic I posted a number of short (1,500 character maximum) messages for my clients on a service available to them through Global Source, who administers my newsletter. I thought in this blog entry I would reproduce the July 8-10 messages in their entirety because they focus on a technical aspect of the Chinese markets that I think is extremely important to understand if we want to understand why volatility is not going to go away. The key point is to distinguish between the types of investment strategies that investors follow (which I discuss more explicitly in my 2013 book on China and in a November 24, 2013, blog entry) and to understand the different ways in which they interpret new information.
The more widely dispersed the investment strategies, and the greater the range of interpretations by which new information is assessed, the more stable a market is likely to be. In China not only is the market wholly speculative, for the reasons I discuss in the blog entry, but even among speculators there seems to have been a dramatic convergence in the way they interpret information. Because this has only been reinforced by the recent behavior of the regulators, it is almost inconceivable to me that we will not see more highly disruptive movement in the Chinese stock markets:
Here are the July 8-10 short messages I posted to clients:
July 8 – China’s markets are unpredictable but mechanical
China’s Spinal Tap stock market is a volatility machine whose every knob has been turned to eleven. Value investors lack the tools they need to project or value cashflow, and so cannot play their stabilizing role no matter what policy enticements are implemented. Policy interventions undermine the regulatory stability that value investors crave, and because the many interventions include attempts to suppress the disruptive impact of shocks, a powerful and poorly-understood consequence is, paradoxically, to magnify the impact of especially large disruptive shocks. With already high expected volatility mechanically jacked up by perhaps the highest margin levels ever recorded, and by the popularity of the investment “strategy” of riding what everyone knows to be a bubble (and of course bailing out just before it bursts), and the events since Friday should be easy to understand, if no less depressing.
If I had to bet I’d bet that a desperate Beijing will wheel out enough firepower eventually to stabilize the markets, but as I describe in my 2001 book, The Volatility Machine, many years of one-way price movement (the 2007-08 stock market disaster being among the few widely-shared exceptions), has left China with the typical developing-country national balance sheet and financial system in which automatic stabilizers are rare and sharply self-reinforcing mechanisms common.
It is important to understand just how mechanical the market collapse has been. By “mechanical” I don’t mean, unfortunately, that if you’re smart enough you can figure out where it is going. You can, however, figure out what might matter and how different outcomes will affect the economy. You should also understand that a recovering market is likely to be highly path-dependent, although much less so should it fall much further.
July 8 – What policies can stabilize the market?
We must avoid the tendency to think of interventions aimed at stabilizing markets as being independent of the structure of the market. In my Peking University seminar I warn my students that because most of the world’s leading economists have been directly or indirectly trained in a tradition that French social scientists, although not French economists, refer to ominously as “Anglo-Saxon”, there is a tendency for us, even Beijing policymakers, to default automatically to an American or British context.
The Chinese stock markets however operate under very different conditions. In a speculative market with few value investors, policies aimed at boosting prices by increasing the present value of discounted future cashflows are largely irrelevant. Given economic expectations that were already weak, and can only have been weakened further after the events of the past few days, prices are still far too high to justify purchasing on value unless interest rates drop much further.
This is why I am not especially impressed by policies, like interest rates cuts or attempts to cut the cost of stock purchases, that are implicitly aimed at encouraging value investors to step up their purchases. We know that increasing the economic value of expected cashflows can cause speculators to step up their purchases, but it is important to understand why. Speculators will purchase in response to policies directed at increasing economic value only if they anticipate a consequent increase in buying by value investors.
July 8 – What might cause speculators to buy?
Broadly speaking speculators buy or sell assets for two reasons:
- Some event is expected to cause, either for technical or fundamental reasons, a near-term change in the supply of or demand for an asset large enough to affect prices, even if only temporarily, and they transact in anticipation of that price change. This event can include technical factors, for example, a change in margin account rules, as clearly happened in China last week, or the impact of MSCI inclusion on foreign purchases, which until it was rejected last month was among the most often-cited reasons for buying Chinese stocks. This event can also include fundamental factors, for example higher-than-expected growth may set off speculative buying if it is expected to increase purchases by value investors.
- Some event, in China the most obvious of which is government signaling, provides a reason for speculators to assume a collective response. Even if the signal has no economic value, for example an editorial in the People’s Daily extolling share purchases as patriotic, speculators will assume that the editorial sets off a self-consciously collective response that becomes self-reinforcing.
There are at least two important qualities that characterize speculative markets. For a value investor the decision to buy or sell depends on his interpretation of a piece of news, while for a speculator it depends on his expectation of the collective interpretation of a piece of news. The former can range widely while the latter tends to converge very quickly. This means that while small changes in the way news is interpreted or in market sentiment will have a limited impact on overall supply or demand in a market dominated by value investors, a market dominated by speculators is extremely sensitive to changes in the way news is interpreted or in market sentiment.
July 8 – What can the government do to move markets move in China?
- Because China’s market is highly speculative, policies that are directed at improving the fundamental value of stocks will have almost no impact on market prices.
- Uncertainty is currently so high that it will have sharply undermined the ability of speculators to agree collectively on how to interpret signals, or on how to judge the impact that technical or fundamental events will have in causing supply to drop or, more importantly, demand to rise.
- Because the obverse policies are blamed for setting off the collapse, some policymakers believe that relaxing rules on margin, or lowering its cost, will have the reverse impact and will stabilize the market. It will not. Such policies can accommodate speculative purchases, but they cannot start the purchasing process until speculators are convinced.
- Speculators will only return to the market if they can be credibly convinced that prices are going to rise, or are credibly convinced that a floor has been established. (The risk is that this might set the stage for another sharp rally.)
- Recent events have seriously undermined the credibility of government signaling.
- I suspect, consequently, that the only way to create a credible floor, or to create credible expectations of rising prices, is by “brute force”. Beijing must force entities under its control, or entities it can influence, to buy shares until all uncertainty is removed.
July 8 – Does the Chinese stock market crash matter?
It is hard to argue that the stock rally had any significant positive economic impact, so some analysts argue that it collapse will not impact the economy either.
This may be true in a direct sense. But there are three important ways the stock market decline might matter. The first is direct. The combination of the rally and the crash may represent a significant shift in wealth from poorer Chinese to richer Chinese. This must cause total consumption to drop, although the amount will depend on the magnitude of the shift, of which we have no information.
Second, and indirectly, if the market crash causes perceptions of economic uncertainty to rise, households might respond by cutting back on consumption.
Third, and also indirectly, if the crash undermines Beijing’s credibility, or confidence in its ability to manage the economy, it could undermine the financial sector, which relies very heavily on the high credibility Beijing enjoys. This is the least likely but most damaging potential impact.
Of course the longer it takes for Beijing to stabilize the market the more its credibility is likely to be undermined. In a worst case scenario Chinese households may blame their losses on their having invested in the stock market because of what is widely perceived as very active cheerleading by policymakers.
July 9 – Should the government have intervened?
After a terrifying beginning with Shanghai down 3.2%, markets turned around dramatically and Shanghai closed up 5.8% on the day. But 194 more companies suspended trading today. Over half of all companies now don’t trade. As I suggested yesterday, it wasn’t the subtle measures that proved most effective but rather outright bans on selling and large concerted buying, including share buyback pledges from nearly 300 SOEs.
Is this the end of the “correction”? Maybe, but only the foolish know for sure. I still think Beijing will eventually halt the slide and set off another rally, but not because there is value at these prices. The rally has always been about excess liquidity and the widespread belief that Beijing’s guarantee now extends to the stock market, and I think with last week’s and this week’s intervention Beijing has invested too much of its credibility to back down.
But the intervention hasn’t been without controversy. In an angry article in Caixin Ling Huawei argues that there had been no threat to the country’s financial system, and that “only a systemic risk that threatens financial stability justifies a government bailout”. Yesterday I pointed out that unless value investors are confident that they have reliable information and understand the rules of the game, they will refuse to participate. Beijing’s intervention, Ling argues, can only have undermined whatever confidence there might have been.
But intervene they did, so now unless Beijing can disentangle the market’s performance and its own credibility, the choices seem limited. Is disentangling possible? I don’t know, but if it is, someone very senior will have to take responsibility for some pretty big decisions.
July 9 – Why do financial crises happen?
- Financial crises are analogous to bank runs. They occur when the liquidity needed to bridge the gaps created by mismatches between assets and liabilities suddenly becomes unavailable. Insolvency by itself is not a sufficient condition, and only leads to a financial crisis when it causes creditors to refuse to roll over liabilities that cannot be serviced out of assets.
- Financial crises can be triggered by a wide variety of events, some seemingly trivial, but they require the following conditions:
- Significant asset and liability mismatches within the country’s balance sheet and financial system, usually exacerbated by highly pro-cyclical mismatches that reinforce exogenous shocks (because highly pro-cyclical entities outperform during periods of economic expansion, there is a natural sorting process in which the longer such periods last, the more a country’s financial system will be tilted towards pro-cyclicality).
- A period in which mutually reinforcing slower-than-expected economic growth and faster-than-expected credit growth create rising uncertainty about the allocation of debt servicing costs.
- A transmission mechanism from the trigger event into the financial system, for example a fall in the price of assets can cause a surge in non-performing loans, or it can cause households to cut back on consumption.
- When these conditions are in place, even a small shock can directly or indirectly (in the latter case by forcing agents to respond adversely to a rise in uncertainty), trigger a self-reinforcing series of events that spiral out of control.
July 9 – Does size matter?
The Chinese stock market panic is unlikely to trigger a financial crisis in China, but not, as many argue, because of its relatively small size and narrowly dispersed ownership. What matters is that although nationally there are significant mismatches between assets and liabilities among individual institutions and within particular sectors of the financial services industry, and these mismatches are highly pro-cyclical, China is protected from crisis by its relatively closed capital account, its high level of reserves, and most importantly of all, the fact that much of the mismatch between assets and liabilities are resolved on a system-wide basis through Beijing’s implicit or explicit guarantee of most components of the country’s financial system.
China is protected from the risk of financial crisis, in other words, mainly by Beijing’s credibility, which remains very high. Without this credibility, more than three decades of rapid growth accommodated by a financial system designed for credit expansion has left the country with what would otherwise be an extraordinarily vulnerable balance sheet.
Inevitably as the country unwinds the balance sheet mismatches, debt has grown more quickly than expected and the economy more slowly in a mutually reinforcing process. This will continue as Beijing rebalances the economy, temporarily increasing the country’s underlying vulnerability until it is able to rein in credit growth and resolve the uncertainty about how the growing gap between debt servicing costs and debt servicing capacity is assigned. As long as the credibility of the implicit Beijing guarantee is maintained, however, I think that while China suffers from excess debt, it is unlikely to suffer from balance sheet instability.
There are two important implications. First, policymakers must ensure that protecting Beijing’s credibility is a priority. Second, investors must ensure that they evaluate changes in credibility accurately.
July 10 – A collective decision to rally
With the market up 5.2% by 1 pm, I think the “correction” is over. Analysts have pointed out the many reasons for skepticism, most importantly, I think, that over half of the listed companies have suspended trading in their shares. The full buying power that Beijing can command, plus the return of speculative buying, has been concentrated on a sharply reduced supply of shares.
So how can we take the market’s revival seriously? Much of the buying was forced, and there were formal and informal restrictions on selling. One of my Chinese friends complained (although he went long early Thursday afternoon): “It is illegal to sell and illegal not to buy, so how can prices not go up?”
In other words neither fundamental reasons (i.e. improvements in value) nor even technical reasons (i.e. more demand than supply) justify confidence that the panic is over and prices will rise next week. It was as if prices were simply legally required to rise, and so they did, and because this legal requirement cannot last, while technical imbalances still favor selling, you might think that the panic is far from over.
But this is a speculative market in which the way information is interpreted has converged tremendously, and it seems that the reaction of the regulators and two good days have provided strong enough a signal to allow a collective interpretation. If today were not Friday, I would bet heavily that prices would surge again tomorrow, but because it is Friday, Chinese investors have two days in which to let the confusion and panic of the past two weeks gnaw away at their confidence in their collective response. If Beijing keeps a tight lid on the news and prevents anything from undermining this perception, I suspect that prices will defy the technical imbalance and rise all week.
July 10 – The Shanghai Composite and the Keynesian beauty contest
For months I have been arguing that the most worrying source of volatility in the Chinese stock market was not its speculative nature nor even the unprecedented use of margin. It was the large share of Chinese investors whose strategy was to ride what they believed to be a bubble. This to me is why the fall was so terrifyingly swift and so hard to contain.
Why? Because a well functioning market requires a wide range of investment strategies and, even among investors with similar strategies, it requires information to be interpreted in a wide range of ways. If investment strategies converge, the impact of new information also converges.
In China we saw a remarkable convergence in investment strategies and in the way information was interpreted. As Keynes explained with his beauty contest example, it is as if while players differed as much as ever on how they define beauty, they agree on how beauty is fashionably defined and know instantaneously of any change in fashion. The consequence is that they always select the same “winner”, and every change in fashion causes an immediate change in selection. This can only cause volatility to explode.
It is too early to say, but the extent and ferocity of the market break and the panicked response of the regulators may result in even further convergence. If the rally is restored I have little doubt that the regulators will take steps to try to limit volatility. Margin, for example, will never be allowed to reach the extent that it had (and this has implications for credit growth, by the way), and a little sand might be thrown into the machinery, perhaps by raising transaction taxes or forcing wider bid-offer spreads. But we shouldn’t overestimate their impacts. If Beijing is able credibly to revive the rally – a big “if” – we will want to watch closely whether once again most investors are cynically riding what they believe to be a bubble.
What next?
So where do things stand now? It is pretty clear to me that Chinese investors recognize that they have collectively decided that the correction has ended and that prices are going to rise. In a speculative market this is all it takes for prices to rise.
But while this recognition seems quite solid, in fact there are a number of factors that can quickly undermine it, and what matters is not new information the suggests prices must fall but rather just new information that undermines confidence in the strength of the consensus. This may not seem as important a distinction but in fact it is. It doesn’t necessarily take bad news to cause prices to fall again. News that undermines our confidence that there is widespread agreement about our collective consensus is enough to do that.
What worries me most is that many of the measures employed by the regulators to halt the panic are unorthodox enough, to put it mildly, that they can introduce all kinds of new convexities and implied options that we don’t fully understand. As we begin to recognize and understand them, however, these might be enough to undermine confidence in our widespread agreement about having reached a consensus.
I realize this is very abstract, but it might help make things a little clearer to consider one of the best-known of the measures employed over the desperate weekend of July 4-5. This measure is described in a recent article in Caixin, which describes a meeting held by the CSRC involving the heads of China’s 21 largest brokers:
After the sit-down, the firms announced in a joint statement that to stabilize the stock market they would spend at least 120 billion yuan combined to buy exchange-traded funds linked to blue-chip stocks listed on the Shenzhen and Shanghai bourses. Moreover, the firms pledged to hold all stock that had been bought with their own money until the index reached at least 4,500 points.
The CSRC ordered the firms to hand over that 120 billion yuan to the China Securities Finance Corp. (CSF), a four-year-old agency co-founded by the country’s major securities and commodity exchanges and clearinghouse to finance brokerage firms’ margin trading and short-selling business, the person said. They were told the money would be used for stock purchases.
At the meeting, the person said, a disagreement arose over how the securities firm’s funds would be managed. One executive proposed forming a committee with representatives from securities firm to make all investment decisions, but that idea was rejected.
All money transfers from the firms were to be completed by 11 a.m. the following Monday, the person who attended the meeting said. The firms complied. Then on July 8, as part of the CSRC strategy, the CSF said it would set aside 260 billion yuan to finance stock purchases by the 21 securities firms.
Why would this matter? Because if brokers are holding large amounts of shares that they are eager to sell, but cannot do so until the index hits 4,500, this creates a barrier, or at least a speed bump, at around 4,500 whose impact as the market races up is hard to determine. This acts effectively as a kind of call option that investors must give away any time they buy stocks while the index is below 4,500.
Here is how I tried to explain it in the discussion following one of the messages I posted above:
How meaningful it is that brokers might not be permitted to sell until the index is above 4,500? If this is a serious constraint, it means that if you buy the index (and this is also true of individual stocks but messier to figure out), you are effectively giving away a call option struck at 4,500.
So how would you value this short position in the implied call? Put differently, would you buy at 4,090 if you thought your upside were capped at 4,500 (up 10%) and your downside “capped” by these put options you correctly see the government giving away? Would you buy at 4,290 (up 5% to get to 4,500)? I have no idea, and I suspect the regulators don’t either, but I am pretty sure you won’t ever pay 4,500 until you think the implied option is about to expire, in which case you’d buy as much as you could get your greedy hands on.
With all that has happened this market could be jam-packed with implicit options, which means trading patterns are going to be very hard to figure out at first. I still think the panic is over – for now, anyway – but mostly because we aren’t smart enough to be uncertain about what is being signalled. On the other hand it is 1:30 a.m. in Beijing, so maybe I am getting way too metaphysical about it.
As an aside, my reference to “these put options you correctly see the government giving away” is in response to a client’s comment that Beijing’s determination to keep the market from falling creates a series of implied put options which investors are long, but there is enough uncertainty about these implied options that it is hard to know how they will impact the market and, more importantly, when they will be “withdrawn”. There are implied options everywhere in this mess of orthodox and unorthodox measures to prop up the markets, and their impact must be to distort convexity in complex ways and to increase volatility, not because of their direct impact on the market but rather because they are complex enough to cause investors to wonder about the robustness of the collective investor-base interpretation.
Protecting Beijing’s credibility
In this market, you buy because you believe that everyone has agreed on the collective interpretation of government signaling. Anything that undermines the confidence you have in the collective interpretation must undermine your decision to buy, and in fact because everyone is watching everyone else, at some point, this can become a collective decision to sell.
Before closing, I want to expand on this part of one of the July 9 messages I sent out to my clients:
China is protected from the risk of financial crisis, in other words, mainly by Beijing’s credibility, which remains very high. Without this credibility, more than three decades of rapid growth accommodated by a financial system designed for credit expansion has left the country with what would otherwise be an extraordinarily vulnerable balance sheet.
I discuss this more in a July 14 OpEd piece I did for the WSJ where I argued that:
In many ways, China is primed for an economic crisis. As the economy performs below expectations quarter after quarter while the debt burden surges, slow growth and rising debt are being tied together in a mutually self-reinforcing process—almost the definition of an unstable balance sheet. There is so much pressure within the financial system right now that twice in the past two years attempts at deregulation have been followed by market disruptions.
We shouldn’t have expected otherwise. History suggests that developing countries that have experienced growth “miracles” tend to develop risky financial systems and unstable national balance sheets. The longer the miracle, the greater the tendency. That’s because in periods of rapid growth, riskier institutions do well. Soon balance sheets across the economy incorporate similar types of risk.
It is not just developing countries that do this, of course. In 1978, during a lecture at NYU, Paul Volcker described the US economy in a way that is very familiar and almost standard for central bankers:
A long period of prosperity breeds confidence, and confidence breeds new standards of what is prudent and what is risky. For a while, the process is self-reinforcing, sustaining investment and risk-taking. But it may also contain some of the seeds of its own demise: eventually natural limits to some of the trends supporting the advances are reached and the advance cannot be sustained so easily…Financial positions are extended and the economy has become more vulnerable to adverse and unexpected developments.
This process is far more technical and systemic than most people realize, and more than is implied in Volcker’s speech. The point is that during expansionary periods it is normal for economic agents to find themselves mismatching assets and liabilities in such a way that the financing gap – the gap between debt-servicing costs and cash flows generated by long term investment – can easily be refinanced by eager bankers (who have learned that excessive optimism is rewarded), in ways that systematically increase profitability. The whole financial system tends to incorporate these kinds of mismatches.
During the contraction phase, however, it suddenly becomes costlier to refinance the gap, and the practice of mismatching assets and liabilities causes debt, not profits, to rise. If the mismatch is severe enough, the balance sheet must lead almost inevitably to crisis – unless government credibility is high enough to guarantee that the mismatch will always be refinanced and the accompanying surge in debt can be absorbed (usually by the government).
That is why defending Beijing’s credibility is key. Conditions will deteriorate, growth will slow more than expected, debt will rise faster than expected, and the refinancing gap will create huge uncertainty about its resolution. Beijing must consequently resist any temptation to expend credibility, which includes taking on debt, unless the alternative is a financial system collapse, or, as Ling Huawei put it in his Caixing article, “only a systemic risk that threatens financial stability justifies a government bailout”.
Two years ago almost to the day we saw a similar sequence, in which minor financial-sector reform was followed by explosive growth in leverage as banks responded “creatively” to the reform. When the regulators tried to reverse the rapid credit growth they accidently triggered the credit crunch of June 20, 2013, in which interbank rates soared to 30% (and probably much higher).
The financial system is structured in a way that makes it increasingly difficult to withstand the slowing growth and rising debt burden that is all but inevitable over the next 3-4 years. The historical precedents suggest that Beijing will be overly confident about its ability to manage rising financial instability, but this creates the risk that at some point it will not be able to do so. This is the real cost of the stock market debacle, both as the stock market soared, largely on the back of the implicit put option Chinese investors thought Beijing had granted them, and even more so when Beijing responded to the panic by committing its full credibility to the existence of this put. As I explained in the WSJ article:
The next two to three years are vitally important. In the best case scenario, Beijing will continue to rebalance its economy and to restructure the country’s balance sheet and financial system. Yet this cannot happen except under much slower growth. Because the debt will burden will continue to rise for at least another four or five years, Beijing will be tested more than ever. To defend itself from crisis, it must become increasingly stingy with its protection.
