The China Syndrome

I am sure that you have all been watching the meltdown in the Chinese stock markets. I posted a blog (in the China Ad Nauseam section) on May 6 about the Chinese stock market, finishing up with the statement that "this is going to get really ugly." It looks like the ugliness is here.

I won't bother to repeat all the statistics about the meltdown, which are readily available elsewhere. I just want to make two points.

The first is the implication of what is happening in China for asset prices around the world. The Chinese government is doing everything possible to prop up the market at this point: cutting interest rates, reducing reserve requirements, providing central bank liquidity to brokers, directing government entities to buy shares, organizing "private sector" (as if that phrase means anything in China) stabilization funds, restricting IPOs, loosening margin requirements, restricting short selling, and suspending share trading. By allowing investors to post real estate as collateral for margin loans, they have literally thrown the kitchen sink at the problem. And still it is not working. Sure, there are occasional up days, just like there were in 2008 and 2009 with the US markets when the US government was throwing spaghetti against the wall in the hope that something would stick, but the overall trend is relentlessly downward.

So the point is this: When the market turns, no one should assume that "the Fed has your back" nor should they count on a "Greenspan/Bernanke/Yellen put." When fundamentals re-assert themselves and bubble sentiment disappears, no government - not the US, not Japan, not China - has proven to have the willingness or the ability to stop the bloodletting. Unless you are willing to believe that a government would endlessly print money and use it to buy shares and other risky assets directly - since any form of indirect action will still rely on the intermediation of investor sentiment - then the Fed most assuredly does not have your back.

The second point is probably even more disturbing. The Communist Party of China ("CPC") has few claims to legitimacy, the most important of which is its alleged wise stewardship of the Chinese economy. The CPC has, quite correctly, judged that there is no material retail demand for democracy in China so long as the economic pie continues to grow. They have even seen that, so long as this condition is met, the Chinese population is willing to endure a large presence of corruption and a large absence of the rule of law, although the long-term dream of the CPC is to become a kind of Singapore writ large: a country where good governance and strong growth have anaesthetised any desire for political expression.

All of which makes the Chinese government's role in the recent stock market bubble even more breathtakingly stupid. In the interest of making it easier to raise equity, hopefully to pay down some of the country's enormous debt load, government officials and the government-controlled press have been pumping the stock market for over a year. This has created in the retail investor, very inexperienced and recently emerged from a world in which the Party attended to every need, an expectation that the government will always make things right. The CPC has therefore become a hostage to fortune: much of its credibility is tied up with a stock exchange over which it actually has little control. And unlike the last time the Chinese markets plunged in 2008, this time the damage and the loss of face will be much more widespread. All of this will likely also occur against a backdrop of a weakening economy, since the debt-fuelled stimulus used in 2008 and 2009 is no longer an option.

The CPC really only has one other claim to legitimacy. I think that we all know what this is - it is the last refuge of the scoundrel. If the stock market meltdown begins to undermine one support for the CPC, then we can reliably predict that it will try to crank up this other one. In fact, we are arguably already seeing this in the country's increased aggressiveness in the South China Sea. As I have said before , the economic incompetence of the Chinese government would be the occasion for some heartfelt Schadenfreude if it weren't for the collateral damage it will cause. If the loss of legitimacy leads the CPC into foreign adventures, then the term "collateral damage" may very well justify its military origin.