By Sunanda Sen, a former Professor of Economics at Jawaharlal Nehru University, New Delhi. Originally published at
Liberalisation of financial markets, as observed in different parts of the world economy, has never contributed to stability—avoiding unforeseen and unbridled movements in prices and quantities—in those markets. Discontinuation of state-level restraints, in deregulated markets, always generates an atmosphere of uncertainty, which itself has been instrumental in generating turbulence, and then leading to crises. Crises in different financial markets across the world are usually preceded by booms, fed by destabilising financial activities in opened-up markets.
The current downslide in China’s stock markets has followed this familiar pattern, with the crash that took place between June and July 2015 foreshowed by an unprecedented boom which came with the fast pace of liberalisation in the financial sector.
Major economic reforms in China, initially launched during the regime change led by Deng Xiao Ping in 1978, continued to be reinforced steadily over the years which followed. As it happened, China could not avoid a downturn in the stock exchanges during the global crisis of 2008, and the Shanghai Composite Index (SSE) dropped sharply from 6000 to 2000 between 2007 and 2009. Efforts on the part of the state to revive the economy by injecting a sum of $585 billion (nearly one-fifth of China’s GDP in 2008), along with other measures, worked to bring about an economic recovery, and the SSE composite index was quick to move above 3000 by 2010.
However, the stimulus, while reviving growth, could not dispel the disruptive forces as financial markets were further opened up. A major cause was the delinking of the renminbi from the dollar. The currency (which had been linked to the dollar since 2005 at a fixed rate of 8.3 RMB/dollar) was subject to moderate appreciation in the coming years, excluding some short periods of depreciation. The latter were related to the expectations of further depreciation of RMB , fueled by developments which included provisions for private holdings of dollars from 2007 and the two-way floating of RMB since 2011, causing leads and lags in trade settlement. Despite the disturbances in the financial market, the current exchange rate of the RMB, hovering since the second quarter of 2015 around 2.2 RMB to the dollar, reflects a rather steady pattern of an appreciating renminbi which in turn is supported by official moves. Here comes the very unique relation between the state and the market in China, with the former continuing to retain its prerogatives in the deregulated markets, especially relating to finance.
The ongoing crisis in China’ s stock market wiped out, in less than a month between June and July 2015, more than $3 trillion of stock holders’ wealth, caused by a 33% drop in stock prices. The Shanghai composite Index (SCI) declined from 4277 to 3806 between June 15 and July 15, 2015. The downslide in China’s stock prices in less than a month has been even sharper that the post-Lehman-Brothers’ crisis on Wall Street, when U.S. stocks fell by 41% over a much longer period, between October 2008 and March 2009.
An explanation of the on-going crisis in China’s stock market needs to relate it to the unprecedented boom which preceeded it. The crash came on the heels of rises of 135% and 150% in stock prices in the Shanghai and Shenzen stock exchanges, respectively, in less than a year. This followed an end to the boom in real estate prices which had its origin in the post-crisis official stimulus package after 2008. With banks operating in Wealth Management Products, and with derivatives accounting for 43.2% of the total volume of currency trading by 2012, the time has been ripe for rampant financial speculation.
While capital account controls in China had been effective in separating renminbi shares (A shares) from dollar-denominated shares (B shares) in the market, it was natural that net short-term portfolio capital inflows to China—only $80 billion in 2014—did not have much of an impact in the stock market. The players who now operate in China’s volatile stock markets consist of a set of rather inexperienced retail traders, all of domestic origin, sharing a pattern very different from those of the institutional investors. Of China’s domestic households, at least 20% are unusually active in stock trading, at least once a month. The brisk stock trading was visible in the large number of new accounts opened during 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, no doubt, was a precarious situation—if not a Ponzi game—especially when stock prices started tumbing downwards in June 2015. As the losses incurred with the drop in stock prices exceeded the borrowed margins, investors were left with little option other than selling further, which exacerbated the crisis starting in the middle of that month.
The end of the stock market boom also might have been conditioned by the rising uncertainties in China’s financial scene, as some changes were expected in the changing global status of the renminbi. The IMF might be willing to consider it for its SDR package, and the Chinese government might attempt to turn it into a convertible currency, backed by rich households keen on more diversified portfolios.
The sharp drop in stock prices has caused the Chinese state to swing in 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 to buy stocks of smaller companies. The other major step taken was to freeze trading of stocks for 50% or more of 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 having a ban in the primary market on new IPOs while continuing to facilitate margin credits by permitting the use of house property as collateral.
Here comes the rather unique relation between the market and the state in China, with the latter in a position to reverse the opening-up process, especially with measures designed to regulate the market.
Interestingly enough, steps as above have been labelled as “contradictions of capitalist China” in the western press and as a “dangerous game of manipulating the stock market” by Larry Summers, the former U.S. Treasury Secretary. Stock market turbulence in China is currently a matter of wide discussion and debate. Despite the fact that stock trading in the Shanghai and Shenzen markets is still a small fraction of the world trade in stocks, the turbulence and the state response have drawn much attention in the western media. Of course, it remains true that while the first-round impact of China’s stock market disturbances will not impact markets beyond China very much, the West knows that the ripple effects of the consequent downturn, along with the official policy to have a “new normal” growth around 7%, 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 turmoil in China’s stock market, still requiring further regulatory measures by the state, remain both an enigma and a paradigm for those who continue to be blinded by the myth of efficiency and stability in free markets!
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