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June 28, 2015

China Central Bank Acts to Avert Risk of Collapse

It didn’t take long: the frazzled People’s Bank of China tries to put a stop to the worst 2-week crash since 1996.

The whole world piled into what had been the hottest stock market in the universe. Chinese stocks had been endlessly hyped in the US and elsewhere. For the smart money, it was a game of chicken; ride it up and get out just before the crash.

Chinese stock markets had more than doubled in 12 months, propelled also by margin debt, cheap credit all around, and the irresistible desire to get rich quick. Everyone in China, from street vendors to housewives, suddenly opened margin accounts in Hong Kong and mainland China, and borrowed money to buy stocks. Outstanding margin debt ballooned to $348 billion, even while insiders were reportedly dumping stocks. A well-oiled wealth-transfer machine.

It was one heck of a party. By early June, it had created $6.5 trillion in “value” over a period of 12 months; 63% of China’s 2014 GDP!

The Chinese government continued to aid and abet that wealth transfer by touting stocks. Even in March, as stocks had already reached dizzying heights, a spokesman for the China Securities Regulatory Commission said that the soaring valuation for Shanghai-listed shares had its own “inevitability and rationality,” such as China’s “improving economic conditions.”

Then someone accidentally turned off the juice.

Over the last ten trading days, the Shanghai Composite Index has plunged 19%, including 7.4% on Friday – the steepest two-week plunge since December 1996. The Shenzhen Composite has given up 20%, and the startup-focused ChiNext Index has plummeted 27% over the last three weeks, including 8.9% on Friday. According to Bloomberg, by Thursday, margin debt has dropped four days in a row. Markets were running out of propellant.

And on Saturday, the People’s Bank of China tried to put a stop to it. It cut its benchmark interest rates by 25 basis points, to 4.85% for the one-year lending rate and to 2% for the one-year bank deposit rate. The fourth cut since November. The last cut on May 10 had stemmed a much smaller rout and had re-ignited the propellants to drive stocks to greater highs. But the descent since has been brutal.

The PBOC also lowered by 50 basis points the reserve requirements for lenders, such as city commercial and rural commercial banks, that specialize in loans to smaller businesses and agricultural enterprises. This would allow these banks to lend more. However, the PBOC didn’t cut the reserve requirements for the largest banks that control much of the financial system.

If stocks continued to plunge, it would trigger more margin calls, which would trigger more forced selling, which would depress prices further and thus trigger more margin calls…. Lu Ting, Chief Economist at Huatai Securities, told Bloomberg that this could lead “to a stampede.” But the government wanted to avoid “panic in the financial markets.”

“There is a risk of collapse in China’s stock market which has substantial margin trading and leveraged funds, and the government aims to reduce that risk,” Xu Gao, chief economist at Everbright Securities in Beijing, told Bloomberg. And in order to “reduce” that risk, the government is trying to get people to take even greater risks.

It has another very good reason to reignite the propellants and keep the wealth-transfer scheme operative for a while longer: state-owned companies that are drowning in debt need to sell shares to raise some fresh money, and for that to happen there needs to be a hot bull market with seething liquidity where speculators are buying up blindly everything they see.

Local governments too are drowning in debt. They need to issue about 2.8 trillion yuan ($451 billion) of debt this year to stay afloat and keep the economic mirage alive. They too need liquidity to do this, but that liquidity has been evaporating. Bloomberg pointed out that the Ministry of Finance last week “failed to meet its target at a bond auction for the first time since July 2014 amid the surge in municipal issuance.”

With all these issues going on, the PBOC “doesn’t want a panic caused by the stock rout to spread,” said Shen Jianguang, chief Asia economist at Mizuho Securities Asia in Hong Kong. “That would lead to financial instability.” Though financial instability is precisely what comes in the wake of an economy powered for years by monetary propellants.

In China’s real economy, meanwhile, a very hard landing is in process.

Courtesy Wolf Richter at Wolf Street (Archive Here)

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