A Chinese tale of Phaethon

Can Beijing manage the soars and dives of its stock chariot?

[caption id="attachment_7893" align="alignnone" width="880"] Beijing photograph by Philip McMaster (Source: Flickr creative commons)[/caption]

Scarcely any government is as good as Beijing when it comes to keeping individual economic activities and market interactions under control, but even the most powerful state capitalist on this planet has tasted some bitterness in the fruit of its own deeds, facing severe consequences of its high-flying economic stimulation plan and inflated ambitions.

Since the beginning of July, Chinese stock market has plummeted by more than 30% in two weeks, after a year of rampant growth of 80%, indicated by the Shanghai Composite Index. If there was a starting point where a potential stock market bubble lurks on the horizon, it should begin with Beijing’s initiative a year ago to help state-owned companies, most of which are old, inefficient, lossmaking, and carrying massive debts, restructure their asset and lessen their dependence on debt financing. For a long time, when state-owned companies lose hundreds of millions of dollars every year, they finance themselves by borrowing from state-owned banks, whether or not the money can ever be paid back. Now these companies, on the brink of insolvency should new loans stop to come in, are told that the unconditional support from the national banks can no longer continue. In addition, they are also told to carry out reforms on staff structure, production technology, internal audit system, and operation and management, all of which incurs a large cry for liquidity. The tightening of credit and structural reform both dictate that state-owned companies improve their equity/debt ratio by attracting more investment. The rationale of reformists in Beijing is simple: in order to revitalize the lossmaking state-owned enterprises, they must first go through recapitalization, allowing diverse, or even private, shareholders into the decision-making circle, of which the process mainly consists of debt-equity swap and IPO.

And an inflating stock market makes this recapitalization much easier, or in another word, the reform of state-owned companies less painful. By issuing stocks whose value can nearly double within a year, companies quickly attract large amounts of investment that provide enough liquidity, allowing them to pay back their due and relieving the state-owned banks from potential bad loans, and along also come the obligation to be financially transparent and the incentive to perform well, as reformists in Beijing have wished.

This is why earlier in June, a CEO of one of China’s biggest banks visiting Oxford answered the question regarding the stock market bubble by stating that “there are many types of bubble, (among which) the stock market bubble is a good bubble. It allows companies to raise capital.”

Fair enough. But shortly after Beijing started the maneuverings to drive the Shanghai Index uphill to ensure a sufficient flow of funds into big national companies, things seemed to have gone out of its control since the beginning of this year, when stock prices went wild and rocketed like a surreal drama. If a butterfly flapping its wings can cause a hurricane across the Atlantic, then a little nudge from the government to bolster the stock market can result in an overwhelming flock of investment and self-affirming overvaluation. Economics tell us that humans are profit-seeking animals; behavioral science tells us that human beings aren’t always homo economicus. In a stock market boom, we get the worst of the two combined: profit-seeking, short-sighted, irrational buyers. Swollen by the temporary boom, investors ranging from idle housewives to risk-addicted bankers poured more and more cash into the system, completing the vicious circle that kept inflating the expectation on return and neglecting risks that were accumulating day by day.

By then it was too late for Beijing to revert to stability. Many times has the CSRC (China Securities Regulatory Committee) warned the risks, a futile attempt to calm the market down and resume the steady path of growth as its initial blueprint has planned, for a roaring stock market, like a wild predator preying after some illusory flesh, simply cannot be stopped.

Well, not until it tripped and sank in the trap that has been there all along: a bubble, by definition, has to go bust someday. When it reaches the bursting point, of course everyone suffers, but in this particular case some less than the others: the state-owned companies have financed themselves and can afford to wait, while investors, particularly those who are using leverage to buy, stand in despair, holding desperate stakes in this desperate game.

This is where we are — ten months after propping up the stock market bubble, Beijing faces the almost insurmountable task of rescuing the stock market from a rocket crash and regaining market’s confidence. Should it fail, the crash will not only erode the growth that Beijing tried so hard to bolster, but it will also bring into question Beijing’s ability to manage the market, the economy, and ultimately, the country. Now that last concern is a very grave matter.

Notably, maintaining stability and growth is the reason why the big, clumsy state-owned companies aren’t allowed to go bankrupt in the first place. In theory, competition should drive firms that are inefficient or producing excess supply to bankruptcy, freeing up production factors to flow into profitable sectors and achieve long-term equilibrium. However, in the case of Chinese state capitalism, state-owned companies, mostly factories, are, like the giant American banks in the financial crisis, too big to fail. Many of them are major employers, if not the only, in towns and villages, and their collapse can mean a surge of unemployment, plunge of local tax revenue, and social unrest. The painful transformation they have to go through, such as changes in operations, management, remuneration structure, product types, and production technology, is therefore the best feasible plan to allocate resources efficiently.

We are yet to find out if the scheme proves successful for the giant national companies, but to refocus on the most urgent matter, as the stock market rout continues, the rescue scheme fraught with unsustainable interventions, growing skepticism, and frantic speculation will have to push on, too. More and more side-effects will emerge: the moral hazard of investors, concerns over Beijing’s faith in marketization, and the question over legal stability that arose with Beijing’s vow to punish “malicious short-selling” are only the tip of the iceberg. After a few rounds of rescue scheme where government agencies inject hundreds of billions of cash into the market and private capital is withdrawn whenever possible, the Chinese stock market will shortly be not much different from a playhouse with several stringed puppets accommodating a few guests who must be tamed first.

Still, most Chinese investors believe (or rather, in their wishful thinking) that Beijing will eventually tame the wild beast and turn around the roller coaster to a steady flow of stream, but costs will be high and lessons should be learned: fiscal policy and monetary policy may be proven effective levers for the authorities, but market maneuverings, even by the strongest state in the most rigid regime, can go out of control and cause chaos, panic, and disruption. Not even Apollo’s own son should dare to manipulate the course of natural order at his whim.

Sarah He is studying for an MPP at the Blavatnik School of Government