The Great Bomb Transfer and Contagion

Through all the talk about the Chinese stock market struggles, a widely held point of faith for analysts is that this will have little to no impact on the real economy or consumers.  The widely cited statistics about the small number of households that own stock is used to support this idea.  Taken in strict isolation, I actually agree that a fall in the stock market will have minimal impact on the real economy.  However, the Chinese stock market absolutely does not exist in a vacuum.

Let me give you a couple of ways the stock market fall is already threatening the broader real economy. First, despite reports that margin financing is declining, the real effect is just a shifting and reclassification to different debt and asset holders.  The large majority of the nearly $800b in stock market support is provided not by high expectations and confidence but by loaned capital and heavily tilted to bank lending.  This will have an enormous impact on the banks capital adequacy ratios as this counts heavily for reserve capital and it merely reallocates the lending from official brokerage/IB margin lending to bank based non-margin lending.  The future losses are transferred from the sellers to the brokers and the CSF.  Whether these are households or firms, the expected losses, accompanying debt and equity, have merely been shifted to brokers and CSF.  From what I am told, the loans to the brokers are no interest no obligation loans meaning  losses are suffered by the public purse rather than the brokers.  Given that China is already projecting a central government budget shortfall of 2.3%, or $250b USD, any significant losses would enormously increase the official projected deficit.  In short, losses and debt aren’t being erased, they are merely being reassigned.  The debt bomb is not being defused.

Second, there is significant evidence that companies are depending on stock profits to maintain profitability or protect against debt calls. Approximately 150 companies shares remain frozen with evidence that they engaged in stock linked debt near the height of the market and would be in technical default or be required to post additional collateral if their stock was trading.  This would require additional selling, potentially concern, or closer examination of their debt obligations.  Easier to just freeze their shares as Beijing tries to come up for a plan.  Nor is this limited to just firms but extends to asset management.  As David Cui notes, brokers have trusts have little capacity to absorb losses before their capital is exhausted.  There are already reports of certain metals investment platforms and products with $6.4 billion frozen seizing up and potentially spreading to banks.  There is incredibly strong evidence that Beijing is attempting to prevent a full scale debt crisis.

Third, though of less direct evidence to Beijing, there is enormous and rapidly accumulating evidence that when China sneezes, other countries catch MERS.  Emerging market currencies are falling rapidly, commodity prices collapsing, increasing the real debt load for a large number of countries heavily exposed to Chinese trade.  Already for instance, there is heightened worries about Australian iron ore miners debt loads and Asian currencies like the ringgit and rupiah are at pre-crisis lows.  Crisis as in 1998 Asian financial crisis not 2008 Global Financial Crisis.  One of the major sub-stories here is that the Chinese RMB has appreciated rapidly against emerging market currencies making it significantly more expensive.  Especially with the rapid outflows some type of engineered weakening or greater flexibility would be welcome, but given SDR aspirations and fear of losing control of the currency, Beijing seems unwilling to choose rational economics over trophy political gains with little substance.

Many analysts have fallen for the tired expression that it must be political.  It can neither be proven true or false but it sounds good for a quote.  While we cannot prove the theory that Beijing is working to prevent a crisis, there is strong and rapidly growing evidence that Beijing is not spending $1.6 trillion USD for political credibility but to ward of much more jarring financial and economic pain.  At the moment, the economic contagion theory is at least as true the theory of political credibility and evidence is mounting much faster and stronger as to its veracity.