BY DANIEL ALTMAN
SEPTEMBER 1, 2015
What are global investors thinking? After two weeks of “Made in China” havoc, share prices in established and emerging markets alike had made a comeback — at least until this morning. But to judge by the major indices, plenty of traders seem to think the worst is over and that the problems on Chinese exchanges have been or will be contained. I disagree.
First, let’s examine investors’ recent behavior and its context. On Aug. 11, China began to devalue its currency — or allowed it to lose value in the market, if you prefer — which pushed other Asian currencies downward, too. The reasons were twofold. First, with Chinese exports becoming cheaper, China’s competitors need their exchange rates to fall as well in order to keep up. Second, the weakness in China’s economy and the tumult in its stock market also lowered expectations for its own import demand. This hurt China’s suppliers in East Asia and beyond, leading foreign investors to sell these companies’ stocks and bonds, and often their countries’ currencies along with them.
Lower exchange rates and lower asset values across the region meant that investors there were losing money. But they also meant that investors had smaller holdings in these markets as a share of their portfolios — and, all other things equal, smaller holdings of emerging markets overall.
This didn’t necessarily mean their portfolios were less risky. Even though the assets from emerging markets accounted for a smaller portion of their holdings, investors may have decided — given all the tumult — that the assets were riskier than they thought, tempting them to reduce their holdings even more. But there’s a flip side: If the investors decided that the fundamentals hadn’t changed, and the emerging markets were just suffering contagion from China, then it might have seemed like the right time to buy.
So what actually happened? In the week leading up to Monday, both Standard & Poor’s 500 index and Asian markets like Malaysia and Thailand gained back about half of their losses for the month. It looked like investors decided that economic fundamentals outside China hadn’t changed. So they moved money from other types of assets — bonds, cash, derivatives, etc. — into stocks, which looked like a bargain.
This may have been a mistake for a couple of reasons. As I wrote last week, and as Robert Shiller, the Nobel Prize winning economist whose work I cited, has since reiterated, stocks may still be overpriced in markets around the world. But more germane to the current situation in China is the fact that the crisis that started in its stock markets may be far from over.
Over the past several days, Beijing has been all over the map: It apparently tried to find the bottom for share prices in its markets and failed, extracted a confession of causing a run on markets from a journalist, and arrested hundreds more people for allegedly spreading rumors that hurt the economy. These are not the actions of a government with its markets under control; they are the actions of a government used to having its people under control.
Options markets, which depend on investors’ expectations for future prices and volatility in stocks, suggest that the Chinese markets have further to fall. There’s a substantial chance that they’re right, since any more downside moves will have a snowball effect. Even more of the money plowed into stocks through margin lending and shadow banking — investment funds managed by banks that promise a high fixed return — will have to be pulled out and not gradually, either.
There’s a chance that the crisis could metastasize to the banking system, too, if stock sales don’t raise enough money to cover the high returns promised to investors in shadow-banking products. If that happens, Chinese banks will have to pay investors out of their own capital — and they may not have enough, especially after Beijing eased capital requirements last year. If the banks come up short, Beijing will have to bail them out again, this time directly — rather than by trying to support share prices.If the banks come up short, Beijing will have to bail them out again, this time directly — rather than by trying to support share prices. Most likely, the government would do so by cashing in some of its reserves of assets denominated in foreign currencies, such as U.S. Treasury notes.
China is already selling Treasuries from its reserves to stop the renminbi from plunging further, after the abortive devaluation shook traders’ confidence in the currency. Only a few months ago, this would have been no big deal. During roughly two decades of export-driven growth and trade surpluses, China built up $4 trillion worth of foreign reserves, far more than it needed merely to protect its currency (which didn’t float freely on global markets, in any case) from speculative attacks. But from July 2014 to July 2015, China’s reserves shrank by more than $300 billion, and the past month is likely to have eroded them even more.
So how much would Beijing be on the hook for if shadow banking blows up? Recent estimates vary widely, but the shadow-banking system was probably worth between $6 trillion and $8 trillion at its peak, so let’s call it $7 trillion. The returns owed to investors may have been about 7 percent on average, or $490 billion. Not all of the shadow-banking funds were invested in stocks, but the other uses of the funds — often loans for municipal construction or infrastructure projects — may also be running losses of as high as 24 percent.
So if the government had to cover a quarter of the promised returns, the cost would be about $120 billion. If it had to cover some of the principal, too, then the cost would be much higher. And when construction projects don’t pay off, and stocks take a nosedive, that outcome becomes a genuine possibility.
I’m not saying that China is on the verge of a full-blown fiscal and monetary crisis. But at the very least, these developments would slow down the economic reforms on which China is pinning its hopes for growth and jobs in the next several years. After all, Beijing won’t be so keen to float its currency when its reserves have taken a huge hit, or liberalize its capital markets when stocks have just emerged from a period of sustained chaos, or let go of state-owned enterprises (like banks) when they’ve already overextended themselves.
In short, the strong likelihood is that this Chinese crisis is far from over. Investors with money in China could soon be in a whole new world of pain, to say nothing of journalists and foreigners, the government’s favorite scapegoats. Falling asset prices will breed discontent in China, too, and as political risk there rises, so will uncertainty in global markets. Economic growth in China will eventually suffer, and economies everywhere that depend on Chinese demand will struggle as well. It’s not a sure thing, of course, but it’s a risk that too few investors appear to be taking seriously.
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