Author: Ryan Littlestone

The Chinese government's struggle with market liberalisation

ForexLive stalwart Lilac has been around since time began (the site's inception ;-) ). She's part of the woodwork, as we say. We're constantly bugging her to share some of her vast wisdom with us and now and again she'll drop a little gem on us

She's got her own roost now called Lilac's Loft and here's one of her latest pieces, on China

The Chinese Way

8 July, and there is nothing traditional about gatherings in mini stock exchange centres across China, where ordinary folk who have been tempted to play, some of whomhave borrowedin order to participate, watched the value of their share portfolios plummeting. They have lost confidence in the market, newly hailed as a symbol of dynamic Chinese capitalism.

"When I chose to buy stocks, I did not think that much, everyone told me they would earn me money."

A few days later, it was over. The Government intervened suddenly and heavily, suspending or banning whole areas of trading. They bought shares to push up prices and it worked. And what a bounce, one of the most rapid stock market gains ever. Panic seemed to pass just like that.
One view is that this was just a hiccup, much like earlier ups and downs in a market known for its endemic volatility. Another, is that this was a hint of a deeper crisis that goes well beyond the stock market.

Since the stock markets in Shanghai and Shenzhen opened in the 1990s their rise has been spectacular, punctuated by dramatic falls and even bigger rises - the Shanghai a shining star, growing at 8, 9 sometimes 10% a year these last decades, so investors have been keen to get a piece of the action. Before the market took a downturn on 12 June, the Shanghai composite had risen by 152% since July 2014 and nearly 60% since the beginning of the year, driven by domestic retailers pursuing sexy stocks and galloping far ahead of economic fundamentals during the period - small wonder then it fell by nearly a third. Up again since then, not quite as much, but the rise over two days marked the strongest since the 2008 crisis. Now this week the market had its 2nd biggest fall in history, its sharpest slide since February 2007 - but why wouldn't investors lock in profits following last week's rally of around 20%, which was, after all, a bit steep? Like everything else in China, even volatility is big.

There's a paradox about these superlatives, though. In a country where everything is big, numbers can be deceptive. The Chinese market is very important in terms of aggregate size. Before the recent falls it was the biggest stock market in Asia by market capitalisation, but in terms of household wealth, it actually isn't that important. Out of a population of 1.35bn people, even if a small fraction invest in the stock market, it is huge. At most 50m households are invested, of which less than 10-15% of their assets are held in stocks - so in these terms a very small percentage is affected. While some have suffered losses, and others who came late to the party have been wiped out, many who lost, lost only their earlier gains.

From the very beginning, Beijing adopted a supportive attitude and people believed their strong policy endorsement to make money as fast as possible. Comments from the state controlled media didn't halt the trend of rising speculation. "This is just the start of the bull market," declared the Official People's daily newspaper in an editorial. "It has support from China's grand development strategy and economic reforms ... the current red hot capital market is a normal reflection of such a development."

The Government was complicit in the boom, because it thought this was the answer to another problem. Banks have refused to lend these last two or three years. This problem isn't specific to China of course, but it is more severe there as the Chinese real economy is more dependent on bank lending than most other developed economies. If banks won't lend, said the Government, go to the stock market instead and sell shares to raise funds. It also encouraged people to buy those shares, with the expectation of making a profit. A new channel for business investment and a new source of funding was opened, so went the thinking, encouraging retail money into the stock market - a naïve plan with good intentions which hasn't worked well. As the market rose, instead of money going into the real economy, even more was sucked out. Instead of returning money to companies for industrial investment purposes, it went straight back into the market.

Among China's investors, the highest proportion of daily turnover comes from domestic retailers, who tend to exhibit herding behaviour: e.g. someone sells, others think they are privy to information so they sell - and it is they who are seeking relief from government intervention. Clearly a more diversified investor base is required, which is why Beijing is trying to attract foreign investors as well as many more institutions, who employ a longer term investment horizon vs. retailers. So it appears the only way to maintain equilibrium is to pump in vast sums.

Share prices already fluctuated Friday on rumours of the authorities retreating from supportive measures, causing the aggressive sell off in Monday's afternoon session; regulators announced over the weekend that lock-up shares worth around 元90.6bn ($14.6bn) would become eligible for trade on China's stock market this week. The amount is more than five times the value of shares unlocked in the past week, which reached around 元17.5bn. Around 3.7bn shares from 28 companies will become tradable on the Shanghai and Shenzhen bourses between 27 and 31 July.

If volatility is not unusual, and shareholding not that widespread, and the stock market is far from being the whole economy, and if most investors only put in a limited amount of their wealth, which they have already seen grow before it tracked back, why the panic, again?

The real issue is that the Government implemented a questionable policy in the slump a few weeks ago. Companies could go into voluntary suspension, without any fundamental reason for doing so. They didn't want their stocks to be heavily sold off, begging the question, why invest in such a company at all? Liquidity has been severely curtailed - at one point on that Tuesday during the first slump for example, 90% of the market was untradeable.

Markets tend to react to what might happen next, and it is within this speculative space that fear can take hold, where expectations become self fulfilling. And then everyone wants to get out first. The downward spiral is all the worse when sell orders are automated. Funds are managed to the effect that if the index falls by maybe 2-3%, positions are liquidated, over and over. Because of the mechanical nature of forced liquidation, the market won't be stabilised until the free fall is halted.

Far more is at stake than reputation

The Government has invested enormous effort into making Shanghai the financial centre of the future. The big strategic objective is to make China a nation of affluent consumers, so any problems impact on this story of China being an aspirational economy and not just a global sweat shop. And this is what Beijing is defending - a national symbol of purpose and direction, that expresses the ambitions of the emerging middle class; a symbol of hope and epochal change from Communism to the market, an economic strategy.

This emerging class of 750m service sector working, urban living people is expected to become the source of greater consumption in China. Consumption as a part of GDP is still only a third, so any economist would pin a strategy on that area for future growth - and Shanghai has become the epicentre, where the stock exchange is expected to oil the wheels of capitalism. An important place too for companies to go for investment and credibility, important as a place for entrepreneurialism. One or two stock market stumbles matter little to a nation of 1.35bn people, but as a measure of the hard paths China has taken and the long history of its transformation, it is a warning of the tensions and struggles ahead.

Growing up in the 70s, people were taught that capitalism was bad - evil in fact, citing exploitation, child labour, working over 12 hours a day - and the future for mankind was socialism. It was the obligation of the Chinese to liberate people all over the world, particularly people living under capitalism, likened to an enslaved society.

Contrast that propaganda then with more recent, starkly different Chinese surveys of Chinese attitudes now.
"Under a market economy people are generally going to be better off, even though some are rich, some are poor - answer yes or no?" Over 85% said yes. And that response is higher than similar surveys in the USA, Japan or Europe. Basically Chinese accept wealth inequality as a consequence of capitalism, more than any other country in the world. Such inequality has become a serious problem in China, in spite of which an overwhelming majority endorses the market economy.

China has come a long way from capitalism as evil, to one of the world's most eager exponents of the free market. Its transformation was possible, because the state steadily withdrew from the economy. Compare China today with other leading economies, Japan and the USA, and the state sector is pretty big - but compare China today with China under Mao, and the role of the State has significantly and consistently declined, creating more room for the market and the private sector.

This highlights the biggest tension of all. China's future is the free market, says the Government, but its latest act has been a dramatic assertion of state control, just like the old days. To Western eyes that looks like a plain contradiction; similarly its people want economic freedom but they also have high expectation that the Government will protect them from the consequences of that freedom. Resolving these contradictions will be an immense task, with a host of difficulties still to be addressed - from technical change to fundamental questions about the whole system.

The idea of lacing socialism with Chinese characteristics, which is the Government mantra, is incongruous. Chinese communism in charge of a very capitalistic economy has always posed a conundrum, and it has become even more enigmatic in the last two years, as the current regime under economist Premier Li Keqiang talks up the market as being an absolute necessity to facilitate further reform. The question is though, what is the market in China? It is regulated, but not completely. It is not transparent, as the Government still plays a heavy role. The institutions needed to run an economy must have an effective rule of law. Regulation, legislation and institutions take time to develop, and until then the market will very likely not be effectively governed.

There is a notion that the authorities still have a 'nuclear' trump card up their sleeve: they could cut the reserve requirement ratio from 18.5% to as little as 5% or even to zero, thus enabling the big state banks to start lending again by injecting $2-3trn into the economy, putting off the day of the big bump with another cycle of growth. I can't see that happening, but those thoughts will keep for another rainy day.

Still scope to fall further - still more scope to rise further

"It's not possible that it will drop like this again tomorrow!"
"If it happens again, it's just not right."
"It can't fall again, tomorrow it has to rise."
"The huge rise and fall isn't good, there should be some rules to this. There don't seem to be any rules."
"We're confident it will go back up, it must be temporary, there must be a limit to how much it can fall!"
"This isn't the first time it has happened, I think we can cope this time."
"We trust our country's leaders."

That is where China is today. At some point the State will have to recognise that the rule of the Party has no place in the proper working of a market economy. Long term growth prospects for blue chips are still incredibly attractive, as is the rise of the Chinese consumer and the shift turning toward e-commerce. But Beijing cannot intervene in the market forever - after all, how much more can the market grow? If the market is big now, think ten or even fifteen times bigger, and how much harder that will be to manage. Can the Government meet all the expectations that come with promising both control and freedom, caught between its Communist past and ambition for the future? Because at the moment, every faltering step brings fear of social unrest in a country with no safety valves. There is a convincing case that this is the reason the Government has stepped in so quickly. Even if the rout only affects a small proportion of urban households, that is still tens of millions of people.

In such an immense economy, the crisis is less about money than social stability, which is paramount during its transformation. What it tells us is that China is having difficulty riding two tigers as they pull in different directions.

The Chinese way. Who knows what they know?

.

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