Hong Kong Phooey - Chinese stock market roulette.

As the Time-Bomb of Athens goes to sleep for the time being (the EUrocracy goes on holiday in August), another potential economic “difficulty” looms in the Far East. Having experienced an enormous appreciation of share values in steps over the last few years (encouraged by the dangerous policy of the Chinese government to use the market as a policy instrument, applying a range of incentives and constraints unknown to Western stock markets), the Hong Kong and Shanghai stock markets have suffered a number of shuddering reverses in recent weeks. Attempts by the government to use their special instruments of control to arrest this process have so far failed.

There are, of course, special circumstances affecting these markets, including the peculiar role of the Government, and the position of China as a rapidly emerging and developing economy. Notwithstanding this, there are worrying similarities between the Chinese situation and the 1929 Wall Street share and banking collapse that crippled much of the world economy for at least 6 years. The boom in Chinese share values was fuelled by the ability of investors to finance share purchases through margin borrowing. The structure of this may be somewhat different from the US 1920s model, but the result was substantially the same - share purchases financed on the assumption that markets will continue to rise indefinitely, exposing shareholders to the possibility that, should share values fall, they would be forced to sell their shares to meet “margin calls” from lenders, potentially producing an avalanche-like collapse of the market. This is what happened in 1929 in the States. Another factor in common is the presence in the market of a huge number of ill-informed individual investors, accompanied by investment and other companies indulging in speculative share dealing. While peering through the murk of Chinese impediments to transparency, the jolting falls of Chinese share values in recent weeks bears a worrying similarity to what happened in the lead-up to the Great Crash. Should confidence in Chinese markets really begin to collapse, the ability of the Chinese government to arrest a resulting share panic is to say the least debatable.

There are already signs of a collapse in confidence. A vox pop done recently in a Chinese share agency (really, a bit like a British or Irish bookmaker’s shop, but allowing people to bet on shares rather than the horses) showed pain and confusion among the punters - sorry - investors; “the market has fallen; it cannot fall further; it must go up again”. Since these interviews, the market has suffered another shuddering drop. Matters are not much helped by the state of Chinese official economic statistics. These are regarded by many Western experts as lacking transparency and unreliable. Should the markets continue to fall, these statistics may turn out to lack the persuasive power to arrest the slide. Worse, the lack of durability in these statistics, if it comes to be appreciated by a significant number of “retail investors”, may make matters much worse. Should the apparently novel concept of a “bubble” come to the notice of such investors in particular, the bubble (which undoubtedly exists) could deflate catastrophically.

Given the difficulty in obtaining a reliable understanding of how the new Chinese economy works in detail, it is difficult to say whether a really big crash would follow the same path as in “1929” - the question of whether Chinese banks could survive such a crash is unclear, for example. Also, the possible consequences for the rest of the world economy in these globalized days is equally unclear. One thing is for sure - a “Chinese Wall Street Crash” would not be good news … Yours from the Great Hall of the People, JR.

The Hong Kong and Shanghai stock markets suffered falls approaching 10 per cent in the last couple of days - in spite of further measures by the Chinese government (“allowing” insurance companies to invest in third party shares, and directing the national pension authorities to increase its stake in Chinese equities). The government now appears to have given up on further market support measures, and the Chinese markets are heading down again. Whether they will stabilize reasonably soon - most western commentators seem to have no idea.

Let’s all hope it does. Western and regional markets have, according to many commentators, reacted "modestly to the Chinese share slide. However, this modest response has involved many billions of, let us say, $US, being wiped off the face value of stock markets from Wall Street to Mumbai, and a number of Far Eastern regional exchanges have recently suffered falls comparable with those on the Chinese exchanges. There seems to be an echo of the argument vented in 2008, whereby it was suggested that the Chinese market and Western markets were in some sense “insulated” from each other, so that a Western collapse (of banks in particular) would not spill over eastwards. It took a bit of time - but, in the end, there was a degree of “washover” into China. Interesting, how the champions of “globalization” so quickly forget its implications when it suits them.

A huge danger of catastrophic collapse of the Chinese stock markets still looms. A recent estimate suggests that an incredible 80 per cent of Chinese investors in equities are individual retail investor, even if these are operating through investment “clubs”, agencies and (shudder !) investment trusts (as they would be described in Western terms.). These people are for the most part trading with margin finance; they are financially speaking uninformed, and appear to approach investment with a mentality that views the stock market as a “better bet” than having a punt on the 3.30 at Happy Valley. Many will have been very hard hit by recent falls in the market, as they will have been required to meet “margin calls” to cover these falls. Many will have had to sell shares to meet these calls. As in 1929, this market structure threatens to produce a “cascade effect”, where falls produce margin-induced selling on a large scale, producing further falls. The effects of continuing falls could produce serious collapse, potentially affecting the household wealth of a huge number of people, and the stability of institutions lending money “on margin”. What this may mean for markets and financial institutions worldwide is very, very unclear.

Oh well. Perhaps we should send in the Masters of the Financial Black Arts, Goldman Sachs. This company ran, not one, but two highly exposed investment trusts that fuelled the 1929 Wall Street Crash, but still bobbed to the surface when the storm subsided, leaving a huge army of “investors” in the Dust Bowl. The same - with variations - happened in every financial crisis since, including the “Lehmann Brothers” great crash of more recent times. As J.K. Galbraith suggested (ironically) in his analysis of the 1929 Crash, “In Goldman Sachs We Trust”. Think about it … JR.