Talking Point

Manic Monday

Why China’s stock market rout proved contagious for the rest of the world

Investors rest in front at computer screens at a brokerage in Shanghai

Please, no more: an awful week for China’s stock markets, though a rebound on Thursday offered some respite

“I’d buy him a double-sized Big Mac, but I wouldn’t give him a state dinner,” Donald Trump told Fox News commentator Bill O’Reilly this week, referring to the upcoming visit to the United States of Chinese leader Xi Jinping.

The Republican presidential candidate felt that Xi deserved the downgraded meal after Monday’s savage sell-off on Wall Street, which had been triggered by an 8.5% fall in Shanghai’s A-share index, a plunge that even Chinese news agency Xinhua was christening as ‘Black Monday’.

Trump was quick to blame Beijing’s policymakers for the downturn in US markets. “They are pulling us down with them,” the frontrunner candidate told O’Reilly.

When asked for his expert view on why China was “collapsing” The Donald replied: “Because it’s funny money. They have a bit fat balloon that is popping, but it’s taking us with it. It’s getting very ugly.”

Trump wasn’t the only Republican candidate to bash the Chinese. Scott Walker wouldn’t even serve up a Big Mac for Xi, calling instead for President Obama to cancel the plans to meet him in Washington.

“Americans are struggling to cope with the fall in today’s markets driven in part by China’s slowing economy and the fact that they actively manipulate their econ omy,” Walker said. “Rather than honouring Chinese President Xi Jinping with an official state visit next month, President Obama should focus on holding China accountable over its increasing attempts to undermine US interests.”

Shanghai fell another 7% on Tuesday, taking its declines across three consecutive trading sessions to a very bearish 22%. And after Monday’s plunge, the headlines were espousing a growing sense of panic. “China meltdown goes global,” wrote the South China Morning Post, while Apple Daily – another Hong Kong newspaper – led with “China exports stock market crisis”.

China – long the world’s growth engine – is suddenly being positioned as the weakest link in the global economy. Fears about how much its economy is slowing down have caused waves of selling to spread from Asian markets to those across Europe. Hence the alarm on Wall Street on Monday, in what a veteran CNBC reporter attested was one of the most dramatic days he had ever witnessed (the Dow dropped almost 1,100 points in the first five minutes of trading, with GE plunging an incredible 21%).

How did we get here?

August, like October, is one of those months that seems to breed financial shocks. But to put things in perspective, the US markets had already been experiencing a fair bit of red prior to Monday – owing to market expectations of an interest rate hike by the Fed next month. However, it seems that events in China prompted a sudden round of frenzied selling in what began to look more like a worldwide panic.

The Chinese economy had not collapsed, of course, although in light of the fears that pulsed through markets you might have supposed something huge had occurred, like a bank failure in Beijing.

True, there were announcements of poor economic data, but these seem to have been deemed all the more significant because they have coincided with a turn for the worse in investors’ psychology towards China.

This change has been partly driven by a unexpected devaluation of the yuan (see WiC292), as well as a feeling that Chinese policymakers have been shown to be more impotent than omnipotent (having flailed around for ways to respond to a falling stock market and a slowing economy).

Foreign investors had began to feel disenchanted in June and July at some of the ham-fisted measures employed to try to halt the plunge in the A-share market. WiC has discussed them at length (indeed, in no single year since we began publication have we written so much about the stock market). But to summarise the situation, the heavily interventionist reaction to the market declines has undermined much of the Xi administration’s talk of ‘trusting to market forces’, while a poorly communicated devaluation of the currency has consolidated the perception that the economy must be slowing a lot faster than the government is comfortable with.

The latter perception was amplified by poor export data and the release of the worst purchasing managers index figure in six years. Anecdotal insights added to the sense of unease, like Gartner’s report that Chinese purchases of smartphones fell – for the first time – in the second quarter of the year. The government’s slow response to a chemical disaster in Tianjin increased the sense of crisis management gone awry (the Wall Street Journal even ran the headline: “Tianjin explosion erodes faith in leadership for many in China”).

So by the end of last week the mood music was already depressed, and views on Beijing’s economic stewardship seemed to be undergoing a profound shift.

“The world is starting to realise China is not nearly as competent as thought, especially in the economic sphere where everyone gave it good grades,” said Fraser Howie, co-author of Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise. Howie also told the UK’s Spectator magazine: “They are now seen as highly reactive and highly incompetent. It should be worrying for everyone.”

Daniel Yergin – author of the highly regarded history of the oil industry The Prize – made a similar comment to CNBC.

“People had confidence the Chinese government knew how to manage their economy. That confidence has been shaken,” he claimed.

A week before the market meltdown the Spectator ran ‘Exit the Dragon’ as its cover story suggesting that China’s “long boom may finally be ending”.

It added: “The consequences for the world will be profound. Forget Greece. This could be the biggest financial story of the year. Even the threat of a significant slowdown in China’s economy could be enough to send the rest of the world tumbling back into recession.”

Similar sentiment was surfacing among economists too, including conjecture that China’s economy was growing at a far slower pace than the officially-claimed 7% rate.

Capital Economics in London calculates the Chinese economy grew just 4.8% in the second quarter, for instance, while Lombard Street puts the figure even lower at 3.7%.

Andrew Polk, a senior economist at the Conference Board in Beijing, believes that output grew at 4% in each of the last two years and will continue to expand at or below that rate for the foreseeable future. “China’s leaders are panicking,” he told the Wall Street Journal.

This then is a snapshot of some of the bleaker sentiments already at play when Monday’s opening bell rang and the Shanghai market did a fairly good imitation of the opening scene in Gladiator (“unleash hell”).

Manic Monday

Many expected a firmer opening in Shanghai on Monday, after the government came out with more measures to boost the stock markets at the weekend: an announcement that the local authority pension funds could allocate up to 30% of their assets into local equities. According to Xinhua, pension funds at all Chinese provinces and cities had net assets of Rmb3.5 trillion ($548 billion) by the end of 2014. Previously, local governments were only allowed to deposit the funds in banks or invest in treasury bonds.

Despite the good news, the market nosedived 8.5%, unleashing a welter of pent-up anxiety about the health of China’s economy and what it could mean for the wider world. Hong Kong sold off first, followed by practically everywhere else.

“Views about China’s economic prospects appear to be shifting from serious concern to near panic,” warned Eswar Prasad, a Cornell University professor and former China head for the International Monetary Fund.

How to explain the scale of Monday’s Shanghai rout? Perhaps in part because local investors understood the limitations of the move to flush pension fund money through the Chinese markets. This was the caustic verdict of an FT Alphaville columnist: “Part of the potential reason for the Monday sell-off was after the Sunday announcement of pension fund capital that would flow into the stock market, it was then announced that it would be a year or more before stocks could be purchased, due to the need to source external managers. This was interpreted, rightly or wrongly, as a move designed to shore up retail confidence by sleight of hand… Beijing has lost credibility with the domestic audience.”

On Tuesday evening the authorities tried again to boost confidence by cutting interest rates and reducing the reserve requirements for banks. The goal: to inject fresh liquidity into the economy and support growth.

Ahead of this announcement most Asian and European markets had bounced back (particularly Germany) and the Dow – cheered by the rate cut – opened about 3% up.

However, in the last hour of trade Tuesday’s gains were wiped out and selling pressure saw the Dow close down 205 points or 1.3%. A trader told Sky News that the last hour had been permeated yet again by the “fear factor relating to China”.

Trading on the unknown?

“For sheer clout, China’s economy outweighs every country in the world save the US. But on transparency, it remains distinctly an emerging market, with murky politics, unreliable data and opaque decisionmaking,” the Wall Street Journal explained this week. “This veil dims the understanding of China’s economy and is an important reason its recent slowdown has produced so much turmoil.”

That’s definitely true. Investors have been second-guessing what might be going on in China’s economy. And when they don’t know with any great confidence, their gut is telling them that it’s worse than the official figures suggest.

Events at Apple – which depends on China for a large chunk of its sales – offer a good example of how a bout of ‘gut’ selling plays out.

On Monday investors piled out of Apple’s stock in the US, driving its value down by 13% at the beginning of the trading session. Their logic was that if China is slowing as much as feared, Apple’s revenues were going to see a significant decline.

But this supposition was soon undermined by Apple boss Tim Cook, who took the unorthodox step of stemming the stampede by sending an email to CNBC host Jim Cramer. In it Cook reassured: “I get updates on our performance in China every day, including this morning, and I can tell you that we have continued to experience strong growth for our business in China through July and August.”

He added that Apple had seen its best performance of the year for its app store in China over the last two weeks.

Cook’s email saw Apple recover $78 billion of market capitalisation, with the stock finishing up 2% on the day as investors absorbed the news that the company’s China business was doing fine.

This example begs the broader question: are investors too fearful about the extent of China’s overall slowdown?

The FT went to investigate for itself on Tuesday, interviewing shoppers in Beijing and Shanghai. And outside Hong Kong Plaza in Shanghai it found customers who said that neither the jittery markets nor fears about the health of the economy had “prompted them to tighten their belts”.

Outside a popular restaurant one office worker told the newspaper: “I don’t think the economic slowdown will affect my life. I am still planning to buy the new iPhone.”

“The rest of the world may feel that the Chinese economy is grinding to a halt, but the shoppers of China’s big cities are not ready to stop spending,” the FT concluded.

Of course, not all of China is doing well. Our article on the struggling northeast region on page 9 makes as much clear. But while they’re thinning in number, China’s cheerleaders haven’t disappeared entirely. Case in point: Fortescue’s chairman Andrew Forrest who spoke this week of his confidence in “the strong fundamentals of the Chinese market”. The iron ore tycoon added that Chinese growth prospects are still strong and that government stimulus, including a $140 billion ‘Belt and Road’ infrastructure plan, will drive demand for steel for decades to come.

What does China’s stock market signal?

Monday’s market rout in Shanghai triggered declines across the world, unsettling investors. But in itself that was a little weird. Up until this point few had viewed A-shares in Shanghai as a proxy for the economy as a whole. Just a year earlier they had started their dizzying ascent. In a normal market this would have suggested an economy going gangbusters. But China is not a typical market, and the upward direction of the A-share indices said more about the levels of liquidity in the system and the appetite of the public to have a punt.

The central government has talked about making the stock market a better means to allocate capital. But this remains a work in progress and for the time being it continues to be as much of a casino as it has been in the past. The signals coming from Shanghai and Shenzhen thus need to be viewed with extreme caution.

That explains some of the exasperation of Stephen McDonnell’s Twitter posting on Wednesday. “So much misinformed and hysterical crap about China’s economy this week,” warned the China correspondent for the Australian Broadcasting Corporation. “Once more: China stockmarket drop not because of the real economy!”

Has the worst already passed?

It seems a key reason why Shanghai’s A-share index plunged through 3,000 was because the government toned down its talk of supporting stock prices. Caixin Weekly reported that a source inside the stock regulator (the CSRC) had told it that non-intervention was the “new normal”. Partly this was because the government had already spent $200 billion intervening in the equity market and $200 billion supporting the renminbi in the currency markets too. But the need to intervene might also have been dwindling. In earlier rescue efforts there were fears about the scale of margin financing and how unwinding this leverage could send tremors through the banking sector. By mid-August margin financing had reduced to much safer levels (down $156 billion from its June peak, reports Bloomberg) and Xue Hexiang, senior strategist at Huatai Securities, reckons that’s why the Shanghai market was allowed to freefall over 8% on Monday.

“The regulator probably thinks the market slump this time hasn’t impacted the broader financial system, or they think the situation is still controllable,” Xue said.

How panicked is Beijing?

On Wednesday the Shanghai market closed down a less frenetic 1.3% and on Thursday it was up 5.3%, ending above the pyschological 3,000 level.

(The blame game appears to be on: Wang Xiaolu, a reporter for Caijing magazine, was arrested this week and accused of “fabricating and spreading false information about securities and futures trading”. Caijing said in a statement that Wang wrote an article for the magazine that claimed the CSRC was looking at how securities companies can withdraw funds from the stock market.)

But elsewhere China’s bureaucratic juggernaut rolls on, doing its best to look unfazed. Preparations for next week’s vast military parade continue and almost nothing has been said about the market turmoil by the country’s leadership. When President Xi was quoted this week, it was about the development of Tibet’s economy rather than China’s turbulent impact on world stock markets.

“In any other country facing such a big crisis you would see senior officials coming out to reassure the public, but since early July no Chinese political heavyweight has come out to say what’s going on or what the government plans to do about it,” Willy Lam, an expert on Chinese politics at the Chinese University of Hong Kong, told the Financial Times this week. “This has fuelled speculation that there are real divisions at the apex of the Party.”

Or perhaps it’s more a case of underlying confidence that the markets have overreacted and that the Chinese economy will deliver its forecast levels of performance.

The view of HSBC economist Qu Hongbin is that full year GDP growth will still come in at 7.1%, for instance. He believes there is ample scope for further monetary easing and says to expect a Rmb1.8 trillion boost from fiscal policy. The ongoing recapitalisation of the policy banks will boost credit, Qu says, plus there are plenty of infrastructure projects where major spending is still required (upgrading urban drainage systems, to cite one).

The Wall Street Journal has also tried to temper some of the more negative headlines. “Some economists say global markets may be overreacting. They point to bright spots: property sales in major Chinese markets are starting to recover, while high downpayment requirements reduce the systemic risk of default. And growth in retail spending has remained above 10%, with shifts to online shopping and services not fully captured in official statistics.”

In an op-ed for the New York Times the Peterson Institute’s China expert Nicholas Lardy even roundly dismissed the new conventional wisdom that China is growing at far slower rates: “[This] popular narrative is not well supported by the facts. There is little evidence that China’s economy is slowing significantly from the 7% pace reported by the government for the first part of the year. Wage growth is running at about 10% annually; the pace of creation of agricultural jobs is stronger than in any previous year; both real disposable income and consumption expenditures of Chinese households are growing strongly. It is not the picture of an economy heading for a hard landing.”

Adding some further perspective Primavera Capital’s Fred Hu points out: “Even at 5% GDP growth, China would generate more growth than any other country.”

But perhaps it’s fitting to conclude, as we started, with the words of Donald Trump. Surprisingly, he has been paying the Chinese president a compliment or two. Although the markets may have lost confidence in China’s leaders over recent weeks, Trump looks like he’s still full of respect. “You know what the big imbalance is?” he told Fox News. “Intelligence. Their leaders are intelligent. Ours aren’t.”


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