On irrational exuberance, China style

Alan Greenspan, previous Chairman of the Federal Reserve, made a speech on December 5, 1996 titled, The Challenge of Central Banking in a Democratic Society, on the level of ‘irrational exuberance’ in the US stock markets, specifically the asset bubble of the dot-com boom. During his speech, markets in Asia were open and immediately dropped 3% as a result of his simple comment.

On Friday, Fed Chairman Janet Yellen will have her words dissected as she makes her speech on the US Economic Outlook (Fed’s What’s Next). As the Fed has not raised rates in eight years, some would argue the world’s central bank is running another session of Greenspan’s irrational exuberance/put. However, I still remain doubtful that the Fed will raise interest rates within the 2015/2016 horizon unless they have figured out a way to raise more money to service the debt payments.

Global news outlets have been covering the large drop in Chinese equity prices, specifically the market indices of Shanghai, Shenzhen and Hong Kong.

Chinese indices YoY

Let’s have a look at the YoY change: Hong Kong = 8%; Shanghai = 75%. These figures don’t seem so bad do they? Well, difference between the 52-week high-low shows that Hong Kong was up 27% and Shanghai up 155%. Did Hong Kong ride on the tails of the Chinese equity-boom? It appears so, yet they have sheltered themselves well from the downfall of Chinese equity prices.

All eyes seemed to have been on Greece, not China. Which is more worrying: tracking the equity market of the nation looking to establish the world reserve currency or a dispute from regional German bank creditors and a small nation that held the Olympics in 2004? Rest-assured, I don’t think ‘China’s 1929′ will be coming any time soon, especially thanks to the fact that the Chinese government is pulling out a lot of stops to prevent further downfall in prices.

Do lower Chinese equity prices help China immerse itself into the MSCI? Perhaps. As the FT reported, “MSCI had made its intentions crystal clear: A shares are ultimately going to get included.” However, are international ‘forces’ (institutions) disrupting the dual-listing on Chinese-Hong Kong markets? I doubt it. Does the downfall represent an element of misjudgment by those of influence in the CCP? Perhaps. Do international institutions crave a holding of a-shares at a discount? Perhaps. Does this shed light on the piece-together manner by which the Chinese economy has been ‘booming’ recently? Perhaps. Only time will tell and answers will certainly surface due to the clout that the Chinese-state media runs.

The situation shows that China went into over-drive during the 2008 financial crisis, was relatively neutral between 2008-2012, and has been arguably supporting the growth figures through its generous financing. So how does a nation react to swelling amounts of debt (153% of GDP in 2008, 282% of GDP in 2015), falling profits, and most importantly: low confidence (as your state-media has been lying about the future direction of the stock market). So how does China stabilize from this? Let’s not forget that China became a superpower through mass production with cheap labour. There is much more on the shoulders of the brains behind the operations now: shadow banking, property boom, legitimacy of the CPP, liberalization of the RMB, and much more. Thus, China is similar to like that of a teenager: full of energy, issues, potential but needs direction on what choices they should make.

Chinese investors should consider following the column of Jake Van der Kamp of the SCMP as he cautioned last month that “This rally is not built to last.” In his June 18 column, Van der Kamp demonstrates the asset-bubble largely stemming from the outcomes of falling interest rates, as he mentions, “It is monetary, I say, because the evidence points to government monkeying with its interest rates and domestic liquidity to prop up a slowing economy.” Highlighting that a side-effect of this monetary policy drug is stock market speculation (/manipulation).


Why do I infer manipulation? The Washington Post highlights that, “It’s a bubble mentality that comes out of the fact that China has more savings than it knows what to do with. Now a big part of the problem is that China’s banks are only allowed to pay people piddling interest rates, all so that exporters can borrow for less.” I think this shows the merits of shadow banking. This will also increase over the near-term as the confidence of Chinese investors will have been impacted. Yet, what do they believe the nightmare scenario to be? China’s stock and housing bubble (i.e. asset bubble) both burst at the same time that interest rates are so low, inflation is low, and the government has pretty much pulled out many of the stops so far.

While Hong Kong has weathered the downfall relatively well, especially given Shanghai-connect, dual-listing and listing of Chinese-centered companies. it needs to be careful in being the ‘middle-man’ in China cleaning its cash (international money laundering) and being controlled by the clout and PBOC of China. Is China a free-market? Far from it. Suspension of trading is to allow for M&A or major corporate finance transactions. According to the SCMP deal watch for July, the first-half 2015 investment banking revenues from China consisted of: US$89.3b in equity, 157.4b in debt, 352.3 in M&A, and 68.4 in loans.

However, as of Wednesday, 1,429 companies (51% of all stocks listed in China) and over 70% of the equity value of the market (by Bloomberg calculations) have been suspended from trading. We all know that it is a lie when these companies cited “significant matters,” yet could this have been a regulatory move? 747 stocks dropped by the maximum daily allowed limit of 10%, yet suspension is usually reserved for unusual price movements (in anticipation of manipulation in a free market) and as such, requires the price to move up and down.

So what has the reaction been to stabilize the downfall? It has been the policy that “Apart from the CSRC, state-backed China Securies Finance vowed it would not just support blue chips but also increase its buying of small and medium-sized company stocks.” In addition to this, the government is pumping money into brokerages to support margin-calls and falling stock prices. It seems here that they are getting a free-ride when stock prices eventually make a turnaround and are left to make near-IPO gains (as the government is essentially underwriting these shares at market-driven prices).

Now regulation and systemic control is one thing, but what about the strength of the market infrastructure? During the trading hours 11:32am until around 3pm on July 8th in the US, 2 out of the 11 exchanges halted trading due to a technical issue. Bloomberg highlights, “That’s one of the things to ponder from this, to see the robustness of how the system works when you knock out one critical component… [such that,] We do have more than one exchange, and that means that if the major market is closed, the orders typically get rerouted to others.” This strength of market infrastructure is a highlight of what a developed market entails, rather than the loose-footing that emerging market crises like China experiences.

Yes, China has been a great market to be an investor, but how will it fare over the next 6 months as “last night the nation’s securities watchdog banned major shareholders, corporate executives and directors from selling stakes in listed companies for six months.” This is very similar to the Bad Boys mentality of ‘we ride together, we die together, bad boys for life’. However, these ‘major shareholders’ concern a much bigger problem.

Bloomberg highlights that, “China, in other words, is going to have a lot of people looking for bailouts: local governments, state-owned companies, and, last on the list, property developers.” Some of these major shareholders have been pledging their securities to collateralize their loans. Talk about irrational. It looks like we are heading for a trio of world events that may have simultaneously represent 2015: Greek debt crisis, Fed rate hike, China stock market bubble. It further highlights a painful truth of free-market vs. state capitalism:

  • “Ultimately, Xi’s government may be making a common mistake among novice investors: doubling down on a losing trade. “The more resources authorities commit to propping up the stock market, the more they ratchet up the potential fallout risks should the market continue to collapse,” says Andrew Wood, an analyst at BMI Research. The government-controlled media, ever optimistic, continues to make the case for buying shares. “Rainbows always appear after rains,” said a recent editorial by the People’s Daily, the voice of the Communist Party of China.

As far as sophistication, China’s market is a piece of cake in comparison to that of the US. Whether simple is good and additional layers are bad, or vice versa, will be a testament of time for the Chinese markets. However, I would venture to assume that the Chinese will follow the positive track of time against sophistication & speed:


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