Why the Chinese QE is doomed to fail

The descent was sharper than the ascent. After hitting a multi-year high of 5,166 on June 12, 2015, the Shanghai Composite Index would drop 20% in two weeks to trade at 4,192 by June 26. After this sharp drop, Chinese bulls, at most, were anticipating some pep-talk from the official mouthpiece People’s Daily and not exactly an address to the nation by either Chinese President Xi Jingping or Premier Li Keqiang.

Most felt that the market correction was in response to the authorities’ action of clamping down on margin financing of stocks. Thus, when the central bank, People’s Bank of China (PBOC), reduced reserve requirements as well as cut interest rate by 25 basis points (the fourth cut since November 2014) it was quite a surprise. However, in light of what followed over the next 13 days, it now seems like an ‘ordinary’ measure to revive the Chinese equity market.

QE weekend

On June 29, China allowed its pension funds to invest upto 30% of their net assets (estimated to be over $100 billion) in the equity market. This was allowed for the first time, possibly in response to the market turmoil. After an initial positive response the market slid again. On July 1, China Securities Regulatory Commission (CSRC) reversed its rule which required investors to provide additional collateral if margin ratio reached 130% thus, re-allowing trading on borrowed money. The market continued to move down leading to the QE (Quantitative easing) weekend of July 3 and 5.

On Friday, July 3, PBOC extended a medium-term (six months) liquidity facility of RMB 250 billion (~ $40 Billion) to 11 banks to support 'weak points of the economy’. On Saturday, state-owned Citic Securities along with 20 other brokerages, promised to invest ~$19.3 billion to create an equity market stabilisation fund. On Sunday, PBOC announced that it will inject an undisclosed amount of capital into China Securities Finance, a state-owned financer of margins to brokers. When the market rose on Monday the authorities felt that the Communist Party of China had managed something for the first time in the world: tame and control the market!

Alas, the delusions of grandeur if any were short-lived. The authorities were back with their efforts to discipline the misbehaving market on July 8 when it banned selling by shareholders who held more than 5% in a company. On July 9, the banking regulator allowed banks to lend money to companies against equity collateral. Over the next 15 days, the stock market moved up by well over 10%, but then it started losing its mojo.

Was there a need?

The actions taken in the QE weekend may be summarised as one where credit was created by the Chinese monetary authority to enable buying of shares from retail stock investors. QE as adopted in the US and the Eurozone in response to the Lehman bankruptcy or PIIGS crisis enabled the creation of credit to first buy toxic assets such as subprime loans and subsequently government treasuries from market participants. This was done, arguably, to maintain the depositor’s confidence in the banking system as well as the confidence of banks in each another.

It is still early days, but the first tranche of the Chinese QE is much smaller compared to the $3.7 trillion of the Fed or €1.1 trillion by the ECB. Moreover, one is not sure what was at risk, for the PBOC to take such extreme measures. As per The Economist, less than 15% of household financial assets are in the stock market and bank funding to stock market activities are only 1.5% of total banking system assets. None of these numbers are of a magnitude which can cause a financial crisis in a large economy such as China. So what explains the fact that China is treating its listed stocks as toxic assets that need to be salvaged with a QE?

Misplaced credit

Over the past 18 months the market rally has been used as endorsements of Xi-Li team’s policy. However, with the Chinese economy in a slowdown mode, people have already started feeling the pinch. This is now haunting the leadership since a fall in market will be interpreted as a failure of the same leadership. Besides, retail participation in the Chinese stock market is very significant. With the ‘shadow financial sector’ or real estate not promising inflation adjusted returns, Chinese savers have flocked to the stock market. Now, if their ‘wealth’ in the stock market also gets reduced it may create widespread disapproval of the Xi-Li team.

Thus, the writing of the Xi-Li put option. The various quasi-government entities have assured investors that support will continue till the Shanghai Index regains the 4,500 mark. As such 4,500 is still, in pure valuation terms, a stratospheric level but the government is willing to indulge the masses. As long as the index remains below 4,500 the government will take measures to ensure that the ‘target’ is hit so that retail sentiment and thus popularity of Xi-Li does not take a hit.

Designed to fail?

The Chinese leadership has positioned itself in a very dangerous position from where there is no easy and possibly glorious exit. Without strong growth, every time the index gets closer to 4,500 there could be a sell-off since the protection offered is only until 4,500. So, the credit infusion is unlikely to meet its ‘target’. The regulator’s decision to ‘bailout’ retail players will institutionalise moral hazard in equities and restricted foreign institutional investors may develop a China aversion. What other EMs including India should fear is that, such investor aversion could spread to their shores in case of a panic.