After several rallies in the past month I said it was just a question of time before the Chinese stock markets tested its recent lows, and today the SSE Composite closed at 1896. It’s become so easy to be skeptical after every surge that I don’t want to fall into the trap of just assuming that each is bound to fail. Still, I have had trouble finding a good reason for any of the recent rallies – all driven primarily, it seems to me, by government attempts to bully the market up – and, sure enough, they have always reversed themselves fairly quickly.
This week in spite of a good Monday (up 2.2%), the market lost ground on Tuesday (down 0.8%) and Wednesday (down 3.2%) with the SSE Composite finishing below its October 16 close of 1910. This is flat from its September 18 close. Remember that Thursday September 18 was the day the government announced a bunch of market-supporting measures, including that Central Huijin was going to buy bank shares. Coming on the back of a global market surge the SSE Composite rallied 9.5% that Friday and ran up another 7.8% the following Monday, adding a further 2.7% over the next three days. Less than four weeks later it has given everything back.
Aside from the continued insanity in the markets, a lot of things have happened during the three days I was at a conference in Shanghai, which means I have not been able to cover events on this blog in the timely way I would have liked. As everyone knows by now CPI and PPI numbers for September were announced on Monday and came in lower than last month’s numbers. I don’t have a lot to say about this beyond what I said in my last entry. On Monday 4th quarter GDP growth was also announced, and at 9% it came in well below everyone’s expectations. We seem to be fully caught up in the game of constant downward revisions in everyone’s estimates for this year’s and next year’s GDP growth numbers.
During the conference (a very interesting one organized by Chatham House) I was asked by one participant about what I thought next year’s GDP growth numbers would be. I had to beg off by saying I am not an economist and the only thing I would want to predict about next year’s numbers is that they are going to be lower than expected.
I say this because it seems to me that we have yet seen the full impact of the global crisis. As I see it, much of the dynamics of the past few years can largely be described as the relationship between Chinese excess savings and American excess consumption, and I think these are going to alter considerably, and not in a benign way. It is the latter that absolutely must change in response to the global crisis. The US is unlikely to continue to have such a low rate of savings as crashing house prices and stock markets reduce so much of the stock of accumulated savings – American savings, in other words, will almost certainly rise as a share of GDP (as probably will, by the way, Europe’s).
This has an inescapable corollary. The rest of the world must inevitably see a rise in consumption that is as great as the US (and European) decline in consumption (the flip side of the rise in savings, made worse if US income stalls or declines), if global demand is to remain unchanged. When you add to this the fact that in large parts of the world we are unlikely to see much of a rise in consumption, and may even see a fall (in Latin America, for example, and among commodity exporters), this in principle means that Chinese (and other Asian) consumption is going to have to grow sharply to absorb most of the US and European decline. If it doesn’t, world growth will slow sharply.
Given that the economies whose savings rate must grow account for anywhere from one-half to two-thirds of world GDP, that puts a huge amount of pressure on a sickly Japan and South Korea and an increasingly unsteady China to generate rising domestic demand. I think it is unlikely that such an increase in domestic demand will happen without a much more massive fiscal expansion in China than most of us are counting on, so my guess is that we are going to continue to revise our growth future estimates for China (and the world) downwards.
One of the impressions I got at the Chatham Conference (ok, not a new impression, but a reinforcement of an old one) is that there is a very sharp split in the views on the Chinese financial system between analysts who have extensive experience in a wide variety of markets and analysts who focus almost exclusively on China. The former seem generally to share my pessimism about the Chinese financial system, whereas the latter are amazingly (to me) sanguine.
Because their main experience of crisis is the recent US crisis, I think these scholars are confusing risky balance sheets in general with the specific risks that brought down foreign banks reently. There is real difficulty here in understanding that even though Chinese banks probably have little exposure to the sub-prime mess or to complex derivatives, it is not those instruments per se that created the crisis, but rather excess risk–taking encouraged by excessively loose money (although to be fair I think most foreign commentators don’t get it either). These instruments were only the way in which banks took on excessive risk, they were not the cause of the excessive risk. Japanese banks in 1990 weren’t brought down by US sub-prime mortgages or toxic derivatives, but rather by old-fashioned loans, and it is useless to think that these former are the only risk to a banking system.
In that light it is worth noting the recent CITIC scandal. Over the weekend some of my students began telling me about rumors of a $2 billion loss at CITIC. This was confirmed on Monday, when it was announced that a badly conceived and unauthorized hedging strategy had gone seriously wrong and, as a consequence, CITIC was facing a huge unexpected loss.
It is still not clear exactly what happened, but from what I can tell this “hedge” was a pretty bizarre hedge – it seemed far more like a misconceived speculative bet to me. According to an article in today’s South China Morning Post it was also not exactly a recent problem:
Questions have also been raised about the timing of Citic’s profit warning, given on Monday. It knew about its currency exposure six weeks ago. Stock exchange rules require listed companies to disclose price-sensitive information promptly.
The article goes on to say “More worryingly, other local companies are exposed to similar currency contracts.” Almost right on cue another problem was announced:
Shenzhen Nanshan Power warned that company officials had signed oil derivatives contracts without the firm’s approval, intensifying fears about internal risk management at mainland companies. Shenzhen-listed Nanshan Power said on Wednesday its officials had signed two option-related contracts with a subsidiary of Goldman Sachs to bet on crude oil prices, although analysts said the contracts were still in the money. Trading in the stock was suspended last week.
What does all this mean? It has been very difficult to get a firm grasp on exactly what is going on in Chinese companies and banks as far as risk management goes. My working assumption is that they have very little risk management experience, very weak rules on disclosure, and a perverse set of incentives. That suggests to me that when faced with the same set of pressures faced by the leading Western corporations and financial institutions – i.e. ferocious liquidity growth and a previous environment of high rewards for excess risk taking – they are even more likely to have made some very risky bets.
Their lack of transparency has kept us from knowing exactly what is happening, but lack of transparency protected US and European banks for only so long before that very lack of transparency became the problem itself. The few glimpses we can get into risk management among Chinese institutions do not give me much comfort. If there is an economic slowdown, prepare to be surprised by all the garbage that comes out.