"Anyone who reads my blog is already likely to know the story. Until the market peaked on June 12, with the Shanghai Composite at 5,178, China had experienced a stock market boom that saw the Shanghai index rising in what seemed like a straight line by more than 135% in one year. The boom seemed almost inexplicable from a fundamental point of view. The market soared as growth expectations for the Chinese economy fell, corporate profitability was squeezed, and banks, who dominate the index, saw a sharp rise in NPLs. What’s more, during this period it was increasingly clear that China’s declining GDP growth was still overly reliant on excessively rapid credit growth, and that to get control of the latter the former would have to drop a lot more.
Although the market peaked in mid-June, the panic really began some time in the first week of July (July 7 is now being referred to by some as China’s “Black Tuesday”), by which time, however, the market had already lost nearly one third of its value. Since late June Beijing had implemented a series of measures to stop the decline, none of which had the desired effect, and by the weekend of July 4-5 there was a sense of complete desperation as the regulators reached for wholly unprecedented attempts to control the fall.
The stock market panic seems to have ended on July 9, when the Shanghai markets closed up 5.8% on the day, followed by strong gains the following Friday and Monday, but Tuesday’s 3.0% decline set hearts fluttering again, and the nervousness did not abate over the next three days as stocks continue to rise, but not without drama. For now I think we can safely say the panic is finally over, but none of the fundamental questions have been resolved and I expect continued volatility. Because I also think the market remains overvalued, however, I have little doubt that we will see at least one more very nasty bear market.
Either way the panic and the policy responses have opened up a ferocious debate on China’s economic reforms and Beijing’s ability to bear the costs of the economic adjustment. Among these costs are volatility. Rebalancing the economy and withdrawing state control over certain aspects of the economy, especially its financial system, will reduce Beijing’s ability to manage the economy smoothly over the short term but it may be necessary in order to prevent a very dangerous surge in volatility over the longer term.
Sunday’s Financial Times included an article with the following:
Critics of the measures unleashed by Beijing last week argue that they point to a fundamental tension at the heart of China’s political economy that a free-floating renminbi would test even more severely. The ruling Chinese Communist party, they argue, is ultimately incapable of surrendering control of crucial facets of the country’s economic and financial system. As one person close to policymakers in Beijing puts it: “The problem with this system is that it cannot tolerate volatility and markets are all about volatility.”
It’s not just that markets are about volatility. It is that volatility can never be eliminated. Volatility in one variable can be suppressed, but only by increasing volatility in another variable or by suppressing it temporarily in exchange for a more disruptive adjustment at some point in the future. When it comes to monetary volatility, for example, whether it is exchange rate volatility or interest rate and money supply volatility, central banks can famously choose to control the former in exchange for greater volatility in the latter, or to control the latter in exchange for greater volatility in the former.
Regulators can never choose how much volatility they will permit, in other words. At best, they might choose the form of volatility they least prefer, and try to control it, but this is almost always a political choice and not an economic one. It is about deciding which economic group will bear the cost of volatility.
But one way or another there will be an enormous amount of volatility within the Chinese economy, not just because it is a relatively poor developing country, which have always been more volatile economically than advanced countries, but also because it is so highly dependent on investment to generate growth. Hyman Minsky argued that economies driven by investment are extremely volatile and overly susceptible to changes in sentiment, and he is almost certainly right.
During the market panic I posted a number of short (1,500 character maximum) messages for my clients on a service available to them through Global Source, who administers my newsletter. I thought in this blog entry I would reproduce the July 8-10 messages in their entirety because they focus on a technical aspect of the Chinese markets that I think is extremely important to understand if we want to understand why volatility is not going to go away. The key point is to distinguish between the types of investment strategies that investors follow (which I discuss more explicitly in my 2013 book on China and in a November 24, 2013, blog entry) and to understand the different ways in which they interpret new information.
The more widely dispersed the investment strategies, and the greater the range of interpretations by which new information is assessed, the more stable a market is likely to be. In China not only is the market wholly speculative, for the reasons I discuss in the blog entry, but even among speculators there seems to have been a dramatic convergence in the way they interpret information. Because this has only been reinforced by the recent behavior of the regulators, it is almost inconceivable to me that we will not see more highly disruptive movement in the Chinese stock markets: