The Shanghai Composite stock index is once again in a bear market, having dropped 20 percent since its recent peak. The index plunged 5.3 percent Monday and at one point Tuesday had fallen another 5.8 percent, though it rebounded to close down only 0.19 percent.
The proximate cause of the drop is the stress in the Chinese interbank market that began last week. The index’s weakness was probably exacerbated Tuesday morning by an article in the official People’s Daily (Chinese) declaring that the stock market regulator and central bank were not “wet nurses†and should not bail out the market.
Interbank rates jumped to double digits last week on liquidity fears, the People’s Bank of China made no public statements or shows of support for the market, rumors of defaults swirled and ome foreign commentators even suggested that China’s financial system was on the verge of a Lehman Brothers-like crash. (It was not.)
While significantly higher than they were two weeks ago, those interbank rates have now dropped well below double digits.
On Monday, the People’s Bank of China publicly issued a statement saying liquidity is at a “reasonable level†while telling commercial banks to strengthen their liquidity management and channel financing to the real, productive sectors of the economy. The central bank had actually circulated this statement to banks on June 17 but only made it public Monday. At a briefing in Shanghai on Tuesday, a central bank official said the interbank rates were now at “reasonable levels†and the seasonal factors that led to the spike would s! oon pass..
So is the credit shortage nearly over and the party about to resume? Don’t bet on it.
China has a debt problem and 2013 credit growth through May, as measured by M2, was 15.8 percent, well above the government’s stated target of 13 percent. If the government is serious about reining in credit growth then achieving the 2013 gross domestic product growth target of 7.5 percent is unlikely. Some investment banks have started to figure this out and are cutting 2013 G.D.P. growth forecasts, again.
The actions by the People’s Bank of China, or lack thereof, in the interbank market last week appear to have been a warning to the banks to get their affairs in order, as well as a real time stress test intended to uncover faults in the system.
That cold turkey approach is risky. There are so many interconnected financial products that the regulators may find it ipossible to predict which troubled instrument may explode into a bigger problem. And conventional wisdom is that Beijing will not allow any significant trust or wealth management products to default, nor will it allow any banks to fail, given the potential impact on social stability, leading bankers to still expect a lifeline.
CHINA LOOKS TO HAVE A CLASSIC MORAL HAZARD PROBLEM. Unless the government either allows defaults and failures, or arrests some bankers, how can it force the banks to improve their risk and liquidity management and really start channeling financing to more productive parts of the economy?
Actually, China arrested a few bankers this year as part of an investigation into shady practices in the interbank market. The crackdown has been led by Wang Qishan, a financial markets expert who is now the Party’s anti-corrupti! on czar. Caixin magazine reported in early May that:
The central bank is mulling broad changes to the interbank bond market in the wake of scandals that have led to the arrest of several executives working for large financial institutions.â€
It is possible that those arrests are unrelated to last week’s interbank market stress. We should, however, consider the possibility that these moves, along with a State Council announcement on June 19 of a package of financial reform proposals, are part of a larger plan to lay the groundwork for the painful and desperately needed reform proposals reportedly up for approval at the Third Plenum of the 18th Party Congress that is expected to meet in October.
As Iwrote in the China Insider column of May 28, it is sometimes hard to understand Chinese economics without paying attention to the politics:
President Xi inherited many challenges, including but not limited to: a troubled economy; a growing debt mess; widespread corruption in the party and society in general; and a huge environmental crisis. Combine those challenges with what looks to be a very significant economic reform agenda that will affect many powerful interests across society and it may be that the logical response from the party is to batten down the ideological hatches, rectify the party, strengthen control over the military, and increase oversight of the media (especially the Internet) and educational institutions before undertaking those jarring economic changes.
The president continues to take steps to tighten control. Last week he ! officially kicked off the Mass Line Education campaign. The campaign is set to last a year and is intended in part to purge the party of formalism, bureaucratism, hedonism and extravagance. It appears that he has also decided he needs to purge the economy of its excesses.
Even if Mr. Xi succeeds in pushing through ambitious economic reform package, as we should assume he will, growth in China is likely to be slower than consensus expectations. A long-time China bull, Arthur Kroeber, managing director of GaveKal Dragonomics, is now pessimistic about growth prospects through 2014, as he wrote in a note to clients last week:
The combination of tighter credit and structural reforms means that with the best of luck China could post G.D.P. growth in 2014 of a bit over 6 percent, its weakest showing in 15 years and well below most current forecasts. A policy mistake such as excessive monetary tightenin could easily push growth below the 6 percent mark. Banks and corporations appear finally to be getting the message that the new government, unlike its predecessor, will not support growth at some arbitrary level through investment stimulus. The dire performance of China’s stock markets in the past two weeks reflects this growing realization among domestic investors, although we suspect stocks have further to fall before weaker growth is fully discounted.
There are a lot of risks to reining in credit and pushing deeper economic reforms, and there are many special interests that will be affected. But Mr. Xi clearly sees that there are greater risks from inaction, and at the end of the day there is no bigger special interest than the party and its ability to maintain power.
