China: Catching a Falling Knife

The People’s Bank of China is effectively funding an effort by a group of brokers to buy equity (to the tune of about $20 billion) in an attempt to stem the massive selloff in Chinese stocks. The news barely checked the relentless decline, which I will expect will resume with a vengeance.

In other words, China is panicking, and attempting to catch a falling knife, as the phrase goes. And that almost never works out well.

Actually, I don’t think that the equity market decline is China’s big problem, except to the extent that it is a harbinger of a dramatic slowing of the growth in the economy, or perhaps an absolute decline in the economy. Countries survive equity market meltdowns. It is the leveraged sector that is the concern. In China, that includes not just banks, but the plethora of shadow banks, trusts, and local government funding vehicles, all with murky interconnections with the banks.

There are pronounced signs of economic stagnation besides the shuddering equity market. The lack of growth in electricity generation is one. The sharp declines in China-sensitive commodities, notably oil, iron ore, and copper are another: oil was down 8 plus percent today. (Cheers, Vlad!) If it was oil alone, one could write it off to the market deciding that a generous Iran deal was imminent. The broad fall suggests that it is China, China, China.

The equity market, and the government’s response to it, is therefore a symptom of this broader economic problem. What the Chinese (and those long energy and metals production) need to be especially concerned about is if a decline in growth sets off a banking or shadow banking crisis. Then the Chinese central bank and government will be in the unenviable position of catching a barrage of plummeting arrows.

About Craig Pirrong 230 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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