Sunday, July 5, 2015

Managing financial market turbulence by "feeling the stones"

The Shanghai and Shenzhen stock market indices have fallen 30% over the past three weeks, as deleveraging margin traders have wiped out $2.8 trillion in market capitalization, on the face of fears about the massive liabilities of financial institutions and corporates. 

In order to reassure and stabilize the markets, Chinese authorities have announced a slew of extraordinary measures. Even more dramatically, the government enlisted industry associations to announce voluntary commitments to stabilize the markets. 

The measures announced the government include relaxation of collateral rules on margin loans to prevent forced liquidation when collateral ratio declined below a certain threshold and extension of margin loan tenures; allowing real estate as an acceptable collateral for margin traders; permitting brokerages to securitize margin loans; crackdown on short-sellers and market manipulators; lowering transaction fees on stock trades by a third; and suspension of the approved initial public offerings (IPOs) of 28 companies (estimated to have realized $645 bn). Some like the suspension of IPOs were done earlier in 2012-14 for 15 months to boost the flagging market.   

The voluntary measures include a pledge by 25 fund managers to help stabilize the market; announcement by the Securities Association of China that brokers would not sell stocks as long as the Shanghai Composite Index remained below 4500 and buy back their own shares; decision by the Asset Management Association of China that asset managers would buy units in their own funds, roll out new products and hold on to shares for at least a year; and a voluntary contribution of $19 bn by 21 of the country's largest brokerages to the establishment of a market stabilization fund. Some of the measures like allowing real estate, non-listed shares, and "other assets" as collateral for margin traders and establishment of a fund to stabilize the stock markets are clear acts of desperation.

In a country where retail investors drive the equity markets, the negative wealth effect from the plunge in equity prices can be substantial. This assumes even greater significance in the backdrop of the government efforts to address one of the biggest structural distortions in the Chinese economy - the very low level of private consumption expenditures. Further, corporates and public sector entities too with their massive debt loads, are critically dependent on a booming equity market to raise capital and defray their debts. 

All these measures strike out against orthodoxy and are exceptional even by Chinese standards. Apart from being remarkable examples of a co-ordination success, the voluntary commitments by industry associations are also a testament to the enormous influence wielded by the government in the functioning of financial markets.

The secret of capitalism with Chinese characteristics has been the effectiveness of the Chinese state to translate its policy intent into reasonably successful outcomes. But, put together, the efforts to stabilize financial markets and manage an orderly deleveraging are likely to be severest test of the Deng's policy of "crossing the river by feeling the stones". The danger today is that the Chinese economy has grown too big and too complex that certain parts of the river are so deep that you cannot feel the stones. Managing a financial market crisis is far more complex than managing the calibrated deregulation of various real economy sectors, liberalization of the political system, and opening up of the financial markets. Not only are there too many parts to the crisis, with completely unknown  and unpredictable interacting reaction functions.  

It looks very likely that China may have entered the deeper parts of the river, where feeling the stones is no longer an option. It may have no choice but to swim against the currents and prevail.

Update 1 (11.07.2015)
More desperate measures with the China Securities Regulatory Commission banning investors with share holdings of more than 5% in a company from selling shares, announcement that the China Securities Finance Corporation, a government-backed fund which among other things also does margin financing for investors, would provide "abundant liquidity" to steady the market and would be effectively the conduit for the central bank to inject funds into the securities market, and directions to state-owned enterprises to buy-back their shares.

Update 2 (18.07.2015)

The scale of public bank lending to CSF was staggering,
The big state-owned banks have lent a combined Rmb1.3tn ($209bn) in recent weeks to the China Securities Finance Corp, for lending on to brokerages to finance their investment in shares and to purchase mutual funds directly... The CSF was established in 2011 to lend to securities brokerages to support margin lending to stock investors. Amid the tumble in equities, however, the government has deployed CSF as a conduit for injecting rescue funds into the stock market...Caijing, a well-known Chinese financial magazine, reported on Friday that the country's sixth-largest lender by assets, China Merchants Bank, provided the largest single loan, at Rmb186bn.

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