China Attempts to Keep Stock Bubble from Deflating

Last month we wrote about the Chinese stock market bubble that was being inflated, largely by delusional retail investors and easy access to margin and debt. But it wasn’t as if something was in the water – Chinese Mom-and-Pop investors were being egged on by their government to invest in the market as the central planners tried to juice economic statistics, bail-out heavily indebted state-owned firms and turn attention away from the sagging real estate market.

Unsurprisingly, the government-fueled rally is coming to an end as both the Shanghai and Shenzhen Indices have crashed over 30% in less than one month! Approximately $3.9 trillion has been wiped out, more than the total annual output of Germany and 16 times Greece’s GDP, to put it in perspective.

Over 1,400 Chinese companies have suspended trading, which is almost 50% of the market.  Some of this is due to stocks hitting maximum daily decline limits imposed by the exchange, but much is due to the companies themselves halting trading. This is because these companies were using their own corporate stock to collateralize or secure loans from banks.

A correction of 30% would actually be somewhat normal and healthy in any market that has surged over 150% in the past year. But this being China, the government couldn’t help themselves from trying to stop the slide. One measure that China’s securities regulator has taken is banning major shareholders, corporate executives and directors from selling stakes in listed companies for six months.

Other actions include suspending new companies from listing (IPOs), restricting short-selling and blocking fund redemptions. Some of the 21 largest brokerage firms in China also set up a $19.4 billion fund to buy shares of the largest Chinese companies, in an effort to prop up and stabilize the markets.

Some believe the measures taken by China’s government are working, pointing to the 10% bounce in the last couple days of trading. Yesterday, a New York Times article entitled Why China’s Stock Market Bailout Just Might Work noted that the “Chinese government’s wealth is huge,” and “they have the resources to pour into this if they want to.”

Regular readers of this blog may quickly spot the fallacy of this statement; governments do not own any wealth, they can only seize or control other people’s’ wealth and direct it to their own purposes. True wealth can only be created through entrepreneurship, not by printing money and then artificially inflating a stock market.

It is true that China’s government could potentially stop the bleeding with enough restrictions and intervention, but this will only make the inevitable all the more painful. In fact, this latest market rout is the direct consequence of their previous attempts to bail-out and stabilize their economy in 2008.

As the WSJ aptly noted, “China’s Bailout Needs a Bailout.” China inflated the current stock market bubble to try to pay for and alleviate the debt overhang from their previous stimulus program which was designed to combat the 2008 crisis.

Thus the cycle repeats itself, and the Chinese authorities refuse to let the economy – drunk on easy credit – sober up. This may sound familiar as our own Federal Reserve also refuses to take the U.S. economy off its morphine drip of 0% interest rates and easy money.

But there is hope. Eventually the laws of economics prevail, and unless stock markets become completely nationalized, they must eventually reflect the true fundamentals of the underlying economy. Until then, investors should continue to stay nimble and cautious.

Chris Kuiper CFA is currently a student and researcher at George Mason University, pursuing a Master’s of Economics. His previous experience includes asset management, investing and banking.