There are two chief methods by which such a crash is transmitted to the domestic economy: first, by a negative ‘wealth’ effect, and secondly, by its impact on those credit institutions which had been financing the run-up and the impact on their clients. To the extent that these two effects can be separated, the second is the most important. Probably no-one, including those inside China’s banking system, really knows the extent to which recent bank lending has been used to finance stockmarket positions. However, the really explosive phase of China’s stockmarket frenzy started in November, and between November 2014 and May 2015, new bank lending amounted to 6.84tr yuan.
Even at the latest valuations, Shanghai and Shenzhen index levels are approximately 50% above end-Oct 2014 levels, soon paper that leaves plenty of scope for margin positions to be paid down without catastrophic pain. But of course, that’s not how margin-position finance works - their very essence is leverage and concentration of positively correlated risk. We can very confident that at least some financial institutions will be in deep trouble, and it be a brave analyst who asserted that none of those risks would develop into systemic threats.
The need to respond to this market disaster finally brings into focus the traditional monetary policy trilemma which Beijing has successfully finessed over the last decade. The monetary policy trilemma is that it is in theory impossible at the same time to pursue a currency target, an independent monetary policy (or, to put it another way, to use monetary policy as a purposeful and effective instrument of economic policy) and to maintain a free capital account.
Over the last 10 years or so, China’s preference was to allow financial repression sufficient to fund an extraordinary growth in the stock of fixed capital, whilst keeping the currency weak enough to allow it to find overseas markets for the resulting surplus production. In response, once-strict capital controls were gradually eroded (both officially and unofficially) as investors sought to buy the undervalued currency, and in response, China both amassed nearly US$4tr in foreign reserves, whilst partly sterilizing the capital inflow by raising reserve ratios on Rmb deposits from 7.5% in 2006 to a peak of 21.5% in 2011.
This strategy was not able to remove the trilemma, but it took the sting out of it, by granting policymakers time to react to changing conditions. But what was gained in policy-flexibility was lost in policy-clarity. Essentially, different financial system actors were independently free to pursue policies which were not necessarily complementary.
That fundamental lack of policy clarity was publicly visible only times of economic stress, when PBOC’s monetary policy were abruptly overturned by State Council decisions - the most obvious example being the credit-splurge mandated at end-2008/early 2009.
It is in this strategic context that China’s stockmarket collapse can be understood. During the first half of the year, policy aims included;
i) maintaining a stable Rmb in order to hasten the day when it is included in the IMF’s SDR;
ii) loosening capital controls whilst sequencing a gradual liberalization of banking and financial markets;
iii) ensuring a sufficiently loose monetary policy to allow nominal growth to sustain the sort of growth previously financed via the financial repression which was in the process of being dismantled.
Even in the best of circumstances, these divergent priorities would bring the policy trilemma into sharper focus. But the trilemma has become increasingly urgent owing to the extraordinary strength of the dollar (and thus the Rmb) between October 2014 and May 2015: the priority of maintaining stability in the Rmb meant there were strict limits on the ability to loosen monetary policy aggressively enough to maintain economic momentum, whilst all the time, the sequencing of loosening capital controls meant the policy mismatch became increasingly obvious. The initial response was logical: ignore the trilemma and buy time by selling foreign reserves (which fell US$238bn between August 2014 and March 2015), and inject cash back into the financial system by cutting reserve ratios by 2.5pps to 17.5% by end-May, with each percentage point cut releasing approximately 3tr yuan back to banking markets. In addition, PBOC put in place schemes extending finance to banks on the basis of specified lending criteria.
Into this environment emerged a stockmarket frenzy. This rapidly became at the very least a useful tactical adjunct by which the policy trilemma could once more be finessed. Specifically, an irresistibly-booming domestic stockmarket to which the authorities could gradually grant foreign access would generate a predictable capital inflow which would allow the pursuit of the Rmb’s inclusion in the SDR to be maintained with rather less negative stress on domestic monetary policy. In addition, of course, growing the stockmarket’s role as an allocator of savings is consistent with the broader policy of a phased dismantling of the structures of financial repression. As time went on, it even became possible to imagine, or at least hope, that the wealth-effect alone might mitigate the dour economic consequences of monetary policy settings.
The crash not only wipes out that way of finessing the monetary policy trilemma, but by generating a whole new generation of yet-to-be-calculated bad loans and savings-destruction, it makes it a whole lot worse, a whole lot sharper, and a whole lot more urgent to recognize.
This is why an almost full-deck of policy measures were announced in the hope of shoring up the market. What one might call the Xi Jinping Put consisted not only of last weekend’s 25bp cut in deposit and lending rates, and a 50bp cut in deposit reserve ratios for commercial banks stretching to a 300bp cut in RRRs for finance companies and non-bank companies, but also the State Council unveiling a draft law to remove the 75% loan-to-deposit ceiling for commercial banks, and official draft guidelines allowing the official pension fund to invest up to 30% of its net assets in equities.
But so far the Xi Jinping Put has failed: on Tuesday, the Shanghai Composite rallied 5.5%, but gave back the entire gains on Wednesday. By end-Friday, the market was down 13.8% from Tuesday’s highs, and - as is usual at this stage of a crisis - the hunt is on for ‘market manipulators’ to blame. Most probably it failed because at some level the market recognizes that whilst the trilemma is unresolved, the Xi Jinping Put cannot be definitive.
One way to see this is to ask: ‘what is missing from the package?’ One thing which is conspicuous by its absence is PBOC injecting money into the market. Weekly totals of PBOC’s open market operations show that from end-April to mid-June PBOC was entirely absent from the market - its net injections of liquidity were . . . zero. Only in the last weeks has PBOC injected cash into the market, adding a paltry Rmb35bn in June 25th auction, and Rmb50bn in the July 2nd auction.
Rather, the job of supplying liquidity to the private sector has been quietly subcontracted out to the Ministry of Finance, which has almost entirely checked the usual seasonal growth of the deposits it keeps in PBOC. In the 3m to May, central government’s deposits in PBOC were down 7.4% yoy , doing this, effectively releasing approximately 250bn yuan of cash to the private sector directly, although the opportunity-benefit in the form of reduced treasury takings will be higher.
So what happens now? The logic of the situation is that the damage inflicted on the financial system will force a clarity of policy which finally over-rides the deep desire to ignore the monetary policy trilemma. In short, monetary policy can become truly expansionary, in which case there is a sacrifice to be made either of the short-term stability of the Rmb, or the phased dismantling of capital controls and other structures of financial repression. The alternative is that the damage to the financial system is unrelieved by monetary policy, but policies to open the capital account and sustain the stability of the Rmb are maintained. Almost certainly that will now entail a hard landing.
In short, the choices have suddenly got both hard and urgent.
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