As China moved from one economic success to another, it looked like the triumph of having the Chinese yuan added as a reserve currency of the world was inevitable. Not only would it underline the rising strength of this economic superpower, but would signify the beginning of the end in the American dominance of international financial markets. The United States it would seem, was going to be unable to deny China’s rightful place in the global institutions dominated by the West.
What a difference a few weeks can make. The Chinese government foolishly squandered in a matter of days, all the careful planning and work that had been done at the end of the 20th century and the beginning of the 21st century. The confidence of bankers and investors in Chinese markets have been shattered. What had now become quite obvious to everyone, was that the government of China was still going to manipulate and control the market inside China.
The careful construct of new regulations dealing with stocks, equities and investment were quickly abridged as Chinese officials panicked in the face of a meltdown in their markets. What had become a necessary correction in an overheated stock market, was now deemed to be a political disaster for the Chinese government. The loss of some $2.7 trillion USD in asset value in the Chinese stock market by early July, made the leadership take more urgent actions to deal with the impending crisis.
The Shanghai Composite had increased in valuation by 150% in twelve months. A 30% correction over the last month was not only inevitable but, had become quite necessary. The earlier steps taken by regulators in China made sense and could be somewhat justified. However, as the market continued to slide, Chinese politicians panicked and put in place far more draconian measures. These new regulations, will ultimately fail to regain the confidence of investors. In fact, they will only make matters far worse in the long run.
Governments have tried for centuries to control markets and they have all ultimately failed. The Chinese leadership saw a rising stock market as essential to the prestige and success of the continued dominance of the country by the Communist Party. The problem is they want to disallow a needed correction, now that the stock market has overheated.
The government unwisely encouraged smaller investors to buy stocks on margin and with borrowed money. This amount ballooned to over $320 billion USD by the beginning of June. It was approaching near 9%, of the total value of the Chinese market at the peak. The sum already exceeded the GDP (Gross Domestic Product) of the former colony of Hong Kong.
Of course, the investors, regulators and government officials themselves were not fully aware of the risks that were involved in borrowing large sums of money to invest in stocks. Quite a few domestic investors were using assets like their homes as collateral, to purchase additional stock in the rapidly expanding market, at the end of 2014 and the first half of 2015.
On June 29th the Shanghai Composite slid an additional 3.3% putting the valuation down over 20%, since the high seen on June 12th. This put Chinese stocks into what many analysts would consider a bear market. It happened despite another interest rate cut by the central bank of China (PBOC). Chinese regulators were even considering the suspension of initial public offerings (IPOs) in an attempt to stabilize the market.
The Chinese government took the further step of announcing that the finance and social security ministries would in the future be permitted to use the state pension fund to invest up to 30% of asset value in securities and stocks. This would allow the flow of an additional $97 billion USD to enter the over expansive market. These actions finally brought about a rebound in the Shanghai Composite on June 30th of 5.6%, but it would probe to be temporary.
A World Bank review in early July of the Chinese market, indicated that major reforms would be needed in order reach a more balanced economy. The government control of 95% of standing assets of the banking system, gives state owned enterprises a disproportionate share of the available credit. Of course, this impacts smaller private firms the most. The World Bank also warned that the instability in the Chinese stock market was a major concern. The review further highlights the weaknesses of the present Chinese system of economics.
The next measure by Chinese regulators was to relax investment rules even further on using borrowed money to speculate on stocks. They also were now allowing individual brokerages to set their own levels of tolerance for margin calls and automatic rollovers in existing lending contracts.
There was an announcement made that effective August 01st transaction fees at the major exchanges would be reduced. On July 06th the biggest brokerage firms in China decided with government support, to purchase shares worth some $19.3 Billion USD. It was an effort to re-instill investor confidence in the Chinese markets. The same day, Chinese regulators formally announced the suspension of all IPOs for an indefinite period of time.
The following day the market reversed again and the losses continued to pile up. Investors were also showing increasing concern at the number of Chinese companies, who were now requesting that trading activity for their shares be suspended. Over one quarter of the total of 2,800 company shares traded on the exchanges of Shanghai and Shenzhen were now inactive. Just a day later and the number of suspended company shares would skyrocket to almost 50%.
On July 09th, the Chinese regulator of securities announced the barring of any shareholder with more than 5% of the total ownership of an individual company, from selling acquired stock for 6 months. The agency took the additional move of declaring that short selling already illegal, would now be thoroughly investigated and prosecuted. The initial reaction of the market seemed positive, but even more companies requested that their shares be withdrawn from active trading.
The same week the government was now ordering listed companies on the exchanges, to produce plans how they would help stabilize their share prices in a declining market. The total decline in the stock market was now at 24.5%, with the temporary bounce from the new regulations still uncertain.
The long term effects are more certain. International investors have watched regulations change almost on a daily basis. They are as a group beginning to limit their exposure to the Chinese market. It has now been reinforced that the rules governing equities and stocks in China, are what the government says they are subject to change almost on a daily basis.
If an investor looks objectively at the Chinese stock market there are 2 main concerns, debt and overvaluation. Since the Chinese government is allowing more margin borrowing in purchasing stocks the speculation will obviously continue.
This debt problem is part of the catalyst in the overvaluation issue. Even after the recent correction, stocks on the Shenzhen market are still trading at 45 times earnings. Although this is down from the high of 68.9 seen in the middle of June, it is still far beyond the average P/E (price earnings ratio) of 18.5% realized on a global basis.
The disallowing of the sales of some stocks and the continued speculation in the market in general, is a repeat of the overheated Chinese real estate sector. It traps capital in a less productive stances, which ends with an overall slowdown in growth and the most productive uses for capital in investment.
The recent actions in the markets sends a major signal to international bankers, that China may not be ready to have the yuan be regarded as an international reserve currency after all. The IMF (International Monetary Fund) meets twice in a decade to conference and decide if there should be major changes initiated, which includes the reserve status for global currencies. The next meeting will take place on October 20th of this year.
The countries who at present enjoy the status of having their domestic money used as a global reserve currency are Australia, Canada, the European Union, Japan, Switzerland, the United Kingdom and most importantly the United States. The United States Dollar alone, captures 62% of world transactions. Half of all the central banks worldwide, hold substantial reserves in American dollars or USD.
Before the stock crisis it was estimated that if China was able to achieve global status for the yuan, they would easily capture 10% to 15% of the world market. It would of mostly come at the expense of the United States Dollar and to a lesser extent the Euro.
For those who oppose the yuan being added to the basket of world reserve currencies, they now have plenty of ammunition to argue against it. One of the biggest opponents has been the United States and a number of European countries, who continue to argue that the Chinese government manipulation of the domestic economy and their currency disqualifies them. Recent actions by Chinese regulators and state officials seem to support that premise.
If the yuan fails to join the reserve currency club, it will provide a temporary reprieve for the United States dollar and the Euro. These two currencies have come under increasing pressure as a result of debt and slower economic growth. However, it is just a delay. In 5 years hence, it will become even more difficult to deny China the role their economic weight and influence in the world of trade and investment merits.