Turbulence and stability in financial markets: China in recent times

Since June, financial markets in China have experienced an unprecedented degree of turbulence and this has given rise to worldwide concerns. Sunanda Sen explains what is happening.

---

LIBERALISATION of financial markets, as observed in different parts of the world economy, has never contributed to what is known as efficient markets with stability, which avoid unforeseen and unbridled movements in prices and quantities. Discontinuation of state-level restraints in deregulated markets always generates an atmosphere of uncertainty, which itself has been instrumental in generating turbulence, and then leading to crises. Crises in different financial markets across the world are generally preceded by booms, fed by destabilising financial activities in opened-up markets.

The downslide in China's stock markets which started in June has followed this familiar pattern, with the crash that took place between June and July foreshadowed by an unprecedented boom which came with the fast pace of liberalisation in the financial sector. The stock market downturn has been followed in recent weeks by an unprecedented depreciation of the Chinese renminbi (RMB) currency, which again was preceded by a substantial dose of appreciation of the currency over some time.

Noticeable policy shifts in China can be observed over recent years, with policies deviating from the earlier pattern of 'guided finance' towards the gradual opening up of financial markets. This started in 2005 with the delinking from the US dollar of the Chinese currency, so long fixed at RMB8.3 to a dollar. Since 2005 the RMB exchange rate has had the status of a managed rate, centred around the dollar, which signified a move for deregulation. Other moves in the same direction included the launch of the Shanghai free trade area in 2014 - a decisive step towards further liberalisation of the financial sector, despite the problems already faced by China with the Hong Kong offshore market and tendencies for round-tripping and arbitrage between the territory and mainland China.

Financial liberalisation in China has already met with turbulence in the financial market, affecting, in recent months, both the stock market and the exchange rate, as mentioned above. The decline in the stock market pulled down the Shanghai Composite Index (SCI) from 5,120 to 3,806 between 11 June and 9 July. The stock market shock wiped out, in less than a month, more than $3 trillion of stockholders' wealth. The downslide has been even steeper than the post-Lehman-Brothers crisis on Wall Street, when US stocks fell by 41%, but over a much longer period, between October 2008 and March 2009.

Attempts by the state to bring back normalcy in the Chinese stock market, as discussed below, were effective for some time in arresting further decline. However, the sharp devaluation of the RMB which followed was instrumental enough to melt down the stock market further, with the SCI dropping precipitously from 3,794 to less than 3,100 between 20-24 August. This has led to shockwaves in the global markets, affecting currencies as well as stocks in different parts of the world.

It may be recalled here that a similar downturn in China's stock exchanges during the global crisis of 2008 had pushed down the SCI sharply from 6,000 to 2,000 between 2007 and 2009. However, efforts by the state to revive the economy by injecting a sum of $585 billion (nearly one-fifth of China's GDP in 2008), along with other measures, worked well to bring about an economic recovery, and the SCI was quick to move above the 3,000 level by 2010.

Preceding boom

An explanation of the ongoing crisis in the Chinese stock market must take into account the unprecedented boom which preceded it. The crash came on the heels of 135% and 150% increases in stock prices in the Shanghai and Shenzhen stock exchanges respectively, in less than a year preceding July 2015. This was a sequel to the end of the boom in the property market, which came with the subprime crisis. With banks operating in wealth management products, and with derivatives accounting for 43.2% of the total volume of currency trading by 2012, the time was ripe for financial speculation in the stock market.

It is interesting to observe that with the rather strict capital account controls in China - which had been effective in separating RMB-denominated shares (so-called A shares) from dollar-denominated shares (B shares) in the stock market, and which of late allowed limited access to qualified foreign institutional investors (FIIs) to trade in the RMB shares - net short-term portfolio capital inflows to China were at a relatively low level of $80 billion by 2014. Accordingly short-term inflows led by the FIIs did not have much of an impact in China's stock market, unlike with most emerging economies which have opened up their financial markets.

In China the majority of players who now operate in the country's volatile Shanghai and Shenzhen stock exchanges include rather inexperienced retail traders of domestic origin, who follow a pattern very different from the institutional investors. Of China's domestic households, at least 20% are unusually active in stock trading, at least once a month. The brisk trading on their part is reflected in the large number of new accounts opened during the boom period which lasted till mid-June and also in the sums borrowed as 'margin money' (to buy stocks), which doubled in the first half of 2015. Looking back, the boom was made possible in large part by borrowed capital financed generously by banks.

This was a precarious situation - if not a Ponzi game - especially when stock prices started tumbling in June. As the losses incurred with the drop exceeded the borrowed margins, investors were left with little option other than selling, which exacerbated the crisis.

The end of the stock market boom might also have been conditioned by the rising uncertainties in China's financial scene, as some changes were already expected in terms of the shifting global status of the RMB. One such factor was the expectation that the RMB may be considered by the International Monetary Fund (IMF) for inclusion in the basket of currencies backing the Special Drawing Right (SDR), which by itself would have contributed to an ultimate convertibility with international acceptability of the Chinese currency. The latter has for some time been one of the goals aspired to by the Chinese authorities. The goal has been backed by the state and also by rich households keen on more diversified portfolios. (The households provide at least 50% of aggregate savings in China and are keen on having overseas financial assets.) As it turned out, the IMF announced on 20 August that the RMB is unlikely to be considered for the SDR basket in the near future. This news came as a jolt to the already depreciating Chinese currency. 

Given the slump in the stock market, the Chinese state, as could be expected, swung into action to combat the sharp drop in stock prices.  Measures taken by the state included a $42 billion loan advanced by the Chinese Security Finance Corporation (CSF) to a set of 21 brokerage firms to buy stocks of blue-chip companies. In addition, the brokerage firms in China vowed to spend another $20 billion to meet the same goal and to buy stocks of smaller companies. The other major step taken was to freeze the trading of stocks by 50% or more of listed companies, followed by a ban on sales of stocks by major owners. Moves were also made to encourage purchases in the secondary market while having a ban in the primary market for new initial public offerings. Margin credits to buy stocks, which were already popular, were further facilitated with the permission to use residential property as collateral. These measures have not so far been able to halt the downturn, as can be seen from the downward trend of the SCI, currently hovering in the 3,100-3,200 range.

RMB depreciation

The bearish tendencies in the stock exchange have been bolstered by the sharp depreciation of the RMB, which declined 3% in less than a week between 11-14 August. On 25 August the RMB crossed 6.41 to a dollar. This had been preceded by a spell of steady appreciation since the delinking of the RMB from the dollar in 2005 when it was at 8.3 to a dollar.

There have been questions as to whether changes in the exchange rate of the RMB are related to state initiatives alone or to market forces. While the delinking of the RMB from its fixed rate to the dollar raised market expectations of further changes, the RMB has in fact continued to be managed with close monitoring by the state. This applies to the current reversal in the rate with the sharp depreciation, which probably followed the official line. With China's current official reserves more than adequate to arrest further declines in the exchange rate if considered undesirable, it is unlikely that the current devaluation of the currency did not have state approval. Contrast this with the brisk activities of the state in recent times to avert further losses in the stock market, which were considered unacceptable. From this angle, the 3% shock depreciation of the RMB can be treated as a state initiative, despite the current debate as to whether it was a policy move or one initiated by the market.

It needs to be pointed out that official policies in the past which included provisions for private holdings of dollars from 2007 and the two-way floating of the RMB since 2011, which caused leads and lags in trade, led to moderate depreciation of the currency which was of a temporary nature and largely linked to expectations of further depreciation.   

As China surprised the world with the recent sharp devaluation of the RMB, there have been ripple effects in the rest of the globe, with concerns over a possible currency war across nations. Developments took a rather dangerous turn on 24 August, with stock markets all over the world as well as currencies moving in a downward direction. On China's part, attempts were made by the central bank, the People's Bank of China, to step in, especially with an announcement that the state would be ready to prevent further downslides in the RMB rate. However, within a few days there was again a slight decline, while there was an official announcement to the effect that the RMB would from then on move with the market. In between, it is worth noting, the IMF had praised China in its currency adjustment, considering that the real exchange rate of the currency was already high.

We point out here that so far there has been a rather unique relationship between the market and the state in China, with the latter in a position to reverse the opening-up process as and when needed, especially with measures designed to regulate the market. But the current ripple effects throughout the global markets which can boomerang and lead to further crisis in China make the scene rather unpredictable.

Interestingly enough, such steps as those above have been seen as reflecting 'contradictions of capitalist China' by Western media, and as a 'dangerous game of manipulating the stock market' by former US Treasury Secretary Larry Summers. The stock market turbulence in China is currently a matter of wide discussion and debate. Despite the fact that stock trading in the Shanghai and Shenzhen exchanges is still only a small fraction of the world trade in stocks, the turbulence and the state response have drawn much attention in the Western media. While the first-round impact of China's stock market disturbances will not affect markets beyond China very much, the West knows that the ripple effects of the consequent downturn, along with the official policy to have a 'new normal' growth of around 7%, will have important implications for the rest of the world.

In judging the current situation, the West seems reluctant to accept the philosophy of the authoritarian Chinese state which, while recognising the role of the market under globalisation, has not given up the role of the state as in a command economy. The turmoil in China's stock market, still requiring further regulatory measures by the state, remains both an enigma and a paradigm for those who continue to be blinded by the myth of efficiency and stability in free markets!                                      

Postscript

Efforts on the part of the Chinese state to restore normalcy in the stock market have continued over August and September. This can be witnessed from the fact that the last major drop in the Shanghai Composite Index (by 282 points) between 24-26 August was followed by the index tracing a stable path over the following month, hovering between 3,080 and 3,282. The ripple effects for the rest of the world, however, extend beyond the stock market developments, as can be seen from the gloom in world markets and even a cautious tone by the US Federal Reserve in relation to the new normal growth path of China, as predicted, of between 6.8-7% per year.

Sunanda Sen is a former Professor of Economics at Jawaharlal Nehru University in New Delhi. This is a revised and updated version of an article which appeared on the Triple Crisis blog (triplecrisis.com).

*Third World Resurgence No. 300, August 2015, pp 22-24