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Sunday, 2 August 2015

China chaos and a new normal? A year in review

Since taking a break this time last year, China's markets and their ongoing story have exploded into international consciousness.  The dawning of not only several "black" trading days, but what was characterised as China's "1929" moment.  So it would be good to note a couple of charts and comparing the similarity of the main Chinese index, the Shanghai Composite (SHCOMP) and the tech index (ChiNext) with some of the greater stock crashes of the last century:

Comparison against 1929 crash (c)

Comparison against the Nasdaq 2000 crash (c)
The desperation with with the Chinese authorities stemmed the losses was intense, including bans on selling, enormous purchases by Chinese SOEs and brokerage companies and of course, attacking "malicious" short-sellers both in China and internationally.  News site Quartz had a good summary of steps taken so far.  In addition as Reuters noted, China sought to exert its authority even outside its jurisdiction approaching Singapore and Hong Kong exchanges to request trading records.

As plenty of sensible commentators noted, the actions by the Chinese authorities are lunacy.  A market majority of shares suspended from trading and/or owned by a state rescue fund, in which participants cannot sell will not operate as a price discovery mechanism (which is the point of a stock market) and with renewed pressure as in Japan, such measures will fail anyway.  Bridgewater Associates, one of the world's largest hedge funds issued a memo reversing its favourable view of China (which they later sought to downplay), while large corporates revised their growth forecasts downwards.  Christopher Balding, an academic in China, explained some of the links between the stock market and the real economy in a blog post.  Investment Bank UBS with a sizeable interest in China business, posted a video of its analysts falling over themselves to try and rationalise why everything would probably just fine though.

Bankers looking concerned (c) UBS

Revisiting the 1990s

It goes without saying that China's efforts to "rebalance" away from its investment driven growth model are in tatters.  Not only are key foundations of the proposed rebalancing compromised (such as likelihood of the currency RMB revaluing, or the China - HK Stock Connect mechanism for outsiders to invest in Chinese shares) but the main thrust of the stock market push, the encouragement of middle-class Chinese to invest in the stock market has failed spectacularly and once again, Chinese savers have seen a transfer of their wealth (usually it is through means such as financial repression including via low interest rates).  Stories of complete losses by amateur investors have emerged, only weeks after the heavy involvement of unsophisticated individuals had been noted in the financial media.

It is worth noting that the aggressive promotion of the Chinese sharemarket by state media had taken place during 2015 in what many interpreted as an attempt to distract from the property market bubble (seen with the collapse of apartment-builder Kaisa earlier in 2015).  In short  a messy situation!

That said though one aspect not mentioned in the discussion about the current situation is China has shut one of its markets before.  It seemed relevant given the period when China shut its market before resuming state support.  And the lessons it serves are not positive.

Referred to as the "327 Incident" (in reference to the code of the Chinese government bond traded), the taking of a significantly losing position by a subsidiary of the Ministry Finance  (a centre of factional power for the Party in the Chinese financial system) in 1995 resulted in the cancellation of trading, the imposition of losses to the securities firm which held the correctly priced profitable position and the imprisonment of its head, and, the closure of the futures market for 18 years (remaining closed throughout the 1990s and only reopening recently).  A good summary below from the Beijing Review:

February 23, 1995 was the darkest day in China's securities history.
In 1992, China had issued 24 billion yuan ($3.6 billion) in Treasury bonds (T-bonds) coded "327" that were set to mature in June 1995.  Upon reaching maturity, the bonds were to be repaid with interest and discounts that reflected inflation.
Guan Jinsheng, then General Manager of the Wanguo Securities Co. Ltd. (Wanguo), expected inflation to dip and estimated that the 327 T-bonds with a par value of 100 yuan ($15) would be repaid at 132 yuan ($20). When the bond's market price hovered around 148 yuan ($22.3), Wanguo decided to hold a short position of the 327 T-bond contracts.
In striking contrast, the China Economic Development Co. Ltd., a wholly owned subsidiary of the Ministry of Finance (MOF), held a long position, expecting the government to raise the bond's discount rate.On February 23, 1995, the MOF announced that it would repay the bond at 148.5 yuan ($22.4).
This news pushed up the bond's price to 151.98 yuan ($22.9). In a desperate attempt to recoup its losses, Wanguo sold an astonishing 1.46 trillion yuan ($220 billion) worth of 327 T-bonds eight minutes before the market closed, dragging its price down to 147.4 yuan ($22.2).
But the SSE announced that the contract sales in the last eight minutes were invalid, leading to 5.6 billion yuan ($843.4 million) in losses for Wanguo.Because of the incident, Wei Wenyuan, then General Manager of SSE, was removed from office for a lack of regulation. Guan Jinsheng was imprisoned and Wanguo was merged into Shenyin Securities Co. Ltd.
If such an approach is followed this time around, then expect a lot more pain.

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