Turmoil in Shanghai

China's financial markets continue to experience turmoil despite multiple attempts to induce stability. The fear is that weakness in equity markets may cause negative feedback loops that lead to defaults and bankruptcies in an indebted, slowing economy. China's slowdown has already hurt global commodity prices. Base metals and gold are at multi-year lows. If China's property and equity bubbles burst, the negative impact may cause further deceleration. Lower growth would make it harder for companies and local governments to service debt. True, stock market capitalisation is not too high, at 110 per cent of China's gross domestic product or GDP (including Hong Kong listings). The Shanghai Composite Index is up 74 per cent in the last 12 months. But the index has fallen 13 per cent in July, and it is down 29 per cent from all-time highs in mid-June. On Monday, the indices fell by over eight per cent, in the largest single-day decline since 2007. Trading is suspended in 125 listed companies. There has been massive selling of gold and base metals on commodity exchanges.

Basically, China's economy seems over-leveraged. Total debt is about 282 per cent of GDP. But GDP growth is estimated to be easing below seven per cent. Transparent, easily monitored federal debt is only about 64 per cent of GDP; municipal debt and provincial government debt is at 60 per cent of GDP. Corporate debt, including vast borrowings by real estate players, is 155 per cent of GDP. There are the usual signs of stress that would be associated with such numbers. Banks have been told to support a $600 billion restructuring of local government debt. One property developer, Kaisa Group, has defaulted overseas. Bankruptcies have occurred in several sectors and even state-owned companies have not been spared. Recent bond offerings by two provincial governments were not fully subscribed. Overseas investors pulled out $225 billion between April and June. The People's Bank of China has cut rates several times. But central bank action may have caused asset bubbles, rather than stimulating activity. Construction and real estate now account for over 30 per cent of GDP with huge over-supply in property markets. In one sign of falling consumption, auto sales and production was negative in June, for the first time since December 2008.

The policy response has been heavy-handed. The media has been told to get market news reports cleared by the regulator, the China Securities Regulatory Commission, "to prevent the spread of false information and market disturbance". Threats were made to discourage "malicious" sellers. A ban was imposed on sales by anybody owning a five per cent stake. The sovereign wealth fund subsidiary, China Securities Finance, has committed $500bn to equity, and 100 state-controlled brokerages have pledged not to sell shares until the index recovers by at least 20 per cent. Banks have been told to accept shares and real estate as collateral for fresh loans - thereby increasing potential risks, since collateral could fall in value.

These measures highlight contradictions between central planning and open markets. China has ambitious plans to liberalise by easing capital account controls, decontrolling domestic interest rates, pushing the renminbi as a reserve currency, integrating Hong Kong with Shanghai, and so on. All those will have to be put on hold until markets stabilise. Given the big rise over the past year, price correction is not really the issue. It is the panic-stricken response which has put more stress on the financial system. As of now, India may gain from China's woes if overseas capital relocates out of Shanghai to Mumbai. But if a domino effect does occur, the entire global economy could take a hit.


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