It happens only in China

The liberalisation of financial markets has never contributed to stability. State-level restraints, when discontinued in de-regulated markets, always generate an atmosphere of uncertainty which itself plays a role in generating a crisis. This is usually preceded by a boom fed by destabilising financial activities in the opened up markets.

The current downslide in China’s stock markets has followed a similar pattern, with the crash that took place in June-July 2015 preceded by an unprecedented boom that came with fast pace of liberalisation in the financial sector.

Major economic reforms in China which were initially launched during the regime change led by Deng Xiao Ping in 1998 continued steadily over the years. China could not avoid a downturn in the stock exchanges during the global crisis of 2008 and the Shanghai Composite Index (SSE) actually dropped sharply from 6000 to 2000 between 2007 and 2009. Efforts to revive the economy by injecting $585 billion (nearly one-fifth of China’s GDP) in 2008, along with other measures, worked to recover the economy by 2010, while in the stock market the SSE composite index moved beyond 3000 by 2010. However, the stimulus could not dispel disruptive forces, as the financial markets were further opened up.

A watershed was the de-linking of the renminbi from the dollar in 2005. Since 1997, despite twin surpluses, the renminbi was able to stay at 8.3 to a dollar. After 2005, this changed. The renminbi was subject to moderate appreciations excluding short periods of depreciation, especially during the last two quarters of 2014. The fluctuations were often driven by private holdings of dollars since 2007, the “two-way float” since September 2011, and the leads and lags in trade settlement, all with the expectation of further depreciation of the renminbi.

Despite the disturbances in the financial market, the current exchange rate, hovering since the second quarter of 2015 at around RMB 2.2 to a dollar, reflects a steady pattern which is supported by official moves. In the unique relationship between the state and the market in China, the former continues to retain its prerogatives in the de-regulated markets, especially relating to finance, as can be seen in China’s stock markets currently.

The ongoing crisis in China’s stock market has wiped off, in less than a month between June and July, more than $3 trillion of stockholders’ wealth, with a 33 per cent drop in stock prices. The slump in China’s stock market was reflected in the Shanghai composite index (SCI) which declined from 4277 to 3806 between June 15 and July 15.The downslide in China’s stock prices in less than a month has been much sharper that the post-Lehman Brothers’ crisis in Wall Street.

An explanation of the ongoing crisis in China’s stock market needs to relate it to the pattern of the unprecedented boom which preceded it. The crash has come on the back of a 135 and 150 per cent rise in stock prices in Shanghai and Shenzen in less than a year. This followed an end to the boom in property prices which had its origin in the post-crisis official stimulus package after 2008. With derivatives accounting for 43.2 per cent of the total trading volume in foreign exchange by 2012, speculation was rife. While capital account controls had been separating the renminbi shares (A Shares) from the dollar denominated (B) shares, it was natural that net short-term portfolio capital inflows to China which in 2014 was only $80billion did not have much of an impact in her stock market.

The players who operate in China’s currently volatile stock markets consist of a set of rather inexperienced retail traders, all of domestic origin, very different from institutional investors. Of China’s domestic households, at least 20 per cent in recent times are found to be unusually active in stock trading. The brisk stock trading was visible in the large number of new accounts opened in the boom period before June 15 and in the sums borrowed as ‘margin money’ to buy stocks, which doubled in the first half of 2015.

Thus much of the boom in China’s stock markets, with the SCI shooting up from 2000 to 5000 in 2014, was made possible only with borrowed capital, mostly financed by banks. This was a precarious game, especially when stock prices had been tumbling since June 2015. While the losses incurred on fall of stock prices exceeded the borrowed margins, investors were left with little option other than selling further, which exacerbated the impending crisis starting mid-June.

The end of the stock market boom might also have been conditioned by rising uncertainties in China’s financial scene. Some of the factors at work are: the changing global status of the renminbi, possibly with the International Monetary Fund willing to consider it for its SDR package, as well as official attempts to turn the renminbi into a convertible currency, backed by rich households keen on a diversified portfolio.

The sharp drop in stock prices led the Chinese state to swing into action. Measures taken include a $42 billion loan advanced by the Security Finance Corporation (CSF) to a set of 21 brokerage firms so they can buy stocks of bluechip companies. In addition, the brokerage firms vowed to spend another $20 billion to meet the same goal and buy stocks of smaller companies. The other major step taken was to freeze trading of stocks for 50 per cent or more listed companies with a ban on sales of stocks by major owners of shares. Steps were also taken to encourage purchases in the secondary market by placing a ban in the primary market on new IPO issues, while continuing to facilitate margin credits by permitting the use of house property as collateral.

The state is in a position to reverse the opening up process, especially with measures designed to regulate the market. Interestingly, the steps described have been labelled “contradictions of capitalist China” in the western press and called a “dangerous game of manipulating the stock market” by Larry Summers, a former secretary of state. Despite the fact that stock trading in Shanghai and Shenzen are still a small fraction of the world trade in stocks, the issue of turbulence and state actions have drawn much attention in the western media. While it remains true that the first round of China’s stock market disturbances will not impact markets beyond China, the ripple effects of a downturn, along with the official policy to have a ‘new normal’ growth around 7 per cent, will have important consequences for the rest of world. In judging the current situation, the West seems reluctant to accept the philosophy of the authoritarian Chinese state which, while recognising the role of the market under globalisation, has not given up the role of the state as in a command economy.

The writer was a professor at Jawaharlal Nehru University, Delhi

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