Monday, July 6, 2015

China crash?

Meanwhile, on the other side of the world, China is doing everything in the textbook to ignite a "bubble."

I dislike that usually undefined term, which carries a lot of normative baggage. But there are a set of steps that governments often take unwittingly and are later criticized for. China's doing them on purpose. And these steps quite often precede large market declines.

Short sales ban: Financial Times: "opened a probe into market manipulation"  ... "The investigation is likely to focus on short selling."  The usual witch hunt, with Chinese characteristics. Owen Lamont has a splendid paper on what often follows short-sales bans. The weekend before TARP and Lehman, the US instituted a short-sales ban on bank stocks, just in case there was someone out there who did not know banks were in trouble and they should sell now. Europe instituted a CDS selling ban in the first PIGS crisis...

Lending to encourage highly leveraged speculation: Wall Street Journal: "Under the planned move, China’s central bank will indirectly help investors borrow to buy shares in a market that had already seen a rapid buildup in debt from so-called margin financing." Procyclical credit supply is named by just about every account of a "bubble" followed by a crash.

Prices depend on supply and demand. As well as increasing demand, limit supply: "A halt to new stock listings."

And more. Quartz offers "A complete list of the Chinese government’s stock-market stimulus (that we know about)" including  "People’s Bank of China will “provide liquidity assistance” to China Securities Finance Corp., a company owned by the stock regulator. The company will use the money to lend to brokerages, which could then make loans to investors to buy stocks."

This scenario often ends badly.

The only thing I can think of that can actually stop a crash is for the central bank to directly print money to buy stocks. And not just a little bit. A pre-announced and limited quantity won't work. The US QE took billions to alter bond prices a few basis points at most. One has to commit to a price floor and a "do what it takes" amount of money, no matter how large or inflationary. I don't know of it ever being tried. It will be interesting to see if China goes that far. They could hide the fact with extensive bailouts of people "borrowing" to buy stocks, or otherwise cover losses or promise to cover losses.

Of course, the right strategy is to leave it alone. The whole point of stocks is that they go down on occasion, without runs, without defaults, and without financial distress. Unless the people and institutions holding them are highly leveraged. Didn't we just learn this lesson?


  1. The HKMA bought Hang Seng futures in the Asian Crisis, see paragraphs 10 and 11 here

    From the text it's not obvious how they financed the purchases - (paragraph 12 implies that they were operating under a currency board); and it's also not obvious that they were targeting a particular level of the Hang Seng index. Either way, an interesting precedent.

  2. Nice post. If China's economy does collapse, what effects will that have on the US economy?

    1. It's not obvious that China's economy and stock market are as linked as they are in the US. The market may crash and the economy chug along. On the other hand, the market may crash, which triggers a wave of defaults and then who knows.

    2. He asked about the effect on the US economy so I'm not sure you answered his question.

      Since 50% of the Chinese economy is devoted to hacking US computer systems (source: CIA Book of Made-up Facts) I don't see much impact on the US other than sporadic shortages of shower flipflops, iPhones, cheap Android devices, and contaminated agricultural products. Countries that rely on exports of raw materials to China are toast. Yeah, I'm looking at you Australia with your real estate bubble.

      The leverage is concerning but what really magnifies the problem in China is the quality (or non-existence) of collateral. China is Jon Corzine's wet dream.

      Meanwhile, we have to figure out how the John Law Virus that makes central bankers insane is propagated and develop a vaccine before we're all voting "OXI".

  3. Big difference between a lesson being taught and anything being learned :(

  4. One must remember that the PRC government and financial institutions think the Chinese economics run on economic laws and rules as approved by the CCP only. There is no need to learn from anybody else experience.

  5. I'm really embarrassed that it took me all day to think of the solution: the government needs to "encourage" all public companies to buy back shares and provide them with cheap easy credit. After all, debt-fueled buybacks with prices at all time highs have been working great in the US. So far.

  6. It would be worth going to your Sinology Department and talking to people there very familiar with how China works (but don't ask for rational expectations models). I did actually study the system once, I do remember them saying that monetary policy worked through a direct loans from the central banks to state banks system, which through institutional structures is very well connected to the rest of the economy. They explained how a command from Beijing very quickly enabled them to loosed or tighten economic conditions. Every time they tightened, analysts in the The City, Wall Street and journalists said high Chinese growth was over, but it was simply the rapid effect by which the system worked. Very sharp oscillations which make things look like the Government is not in control, but which is not necessarily the case.

  7. Hello Prof. Cochrane,

    you wrote: "Unless the people and institutions holding them are highly leveraged". Great point! I'm not a close follower of Chinese markets but my colleagues are and I'm told that the Chinese stock market is held mainly by individuals who are highly leveraged (buying individual stocks on margin, borrowing from family/friends). What would be the policy recommendation in this case?

    1. Federico,

      I am not real familiar with the debt contracts associated with margin buying of stocks.

      I think what China is trying to do is to provide some sort of social insurance policy for the public (similar to the U. S. Social Security system) without resorting to direct taxation - but I could be wrong.

      In essence, this would be what the Republicans were shooting for in G. W. Bush's first tem in office - privatized Social Security.

      For that to function properly there would need to be some method of either staggering the expiration of that debt or making the debt life term.

      Staggered duration fixed term debt allows time for buyers and sellers of equity to be matched in a reasonable time frame. The last thing the Chinese government would want would be for all the private debt to come due on the same day resulting in a massive rush to sell.

      With life term debt an individual would make regular interest payments with no intent on ever paying back the principle. In that way it is similar to U. S. taxation, the only difference would be that the Chinese central bank would be the recipient of the interest payments on the private debt whereas the U. S. government is the recipient of taxes.

  8. The news out of China is incredible. Since trading is halted on so many stocks the shorts can't cover. That has to be a garment-rending moment. It also prevents the short covers from providing a price floor.

    The collateral situation looks worse every time I look. Unoccupied condos in ghost cities can be used as collateral for margin debt. It turns out that many publicly traded companies have used their shares as collateral for loans. Copper and other industrial metals posted as collateral on loans - if you can find them after the re-re-re-hypothecation - have lost significant value.

    Hoo boy.

  9. As I understand it, foreigners are barred from buying securities in China. One way for the Chinese government to support the market would be to allow westerners to invest directly.

    Anyone wanting to gamble on China can already invest in copper, iron or coking coal producers in the developed world but some people might want to invest directly.

  10. China needs extended fiscal stimulus to resurrect its frail economy, says Jamie Fahy, analyst, Global Macro Strategy & Asset allocation at Citi who sees PBOC's rate cut late on Wednesday as "not enough." Fahy also thinks China's exchange rate is extremely overvalued and real interest rates within China very high. Read more...


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