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Opinion

Don't count on Beijing to sit still while markets tumble

Regulators are showing more restraint than in 2015 but their limits will be tested

Expect the Chinese government to come to the rescue if markets go wrong.   © AP

China's capital markets are under great stress.

Trading volumes are thinning as investors run for the exits with prices falling and volatility rising. Blue chip stocks in Shanghai and Shenzhen are trading lower than they have in 2 1/2 years. Shares of smaller companies are doing even worse.

ChiNext, a board tracking Shenzhen's most dynamic listed companies, is at levels not seen since late 2014. The yuan has slipped similarly, briefly breaking through the level of 6.9 to the U.S. dollar recently in offshore markets. Bond yields have been falling, with mutual fund managers seeing investors shifting their investments out of equity funds and into fixed-income ones seen as a safer option.

Chinese markets are no stranger to panic and the mood is very bleak. If, as U.S. President Donald Trump would have it, stock market performance is a measure of who's winning and losing in the trade war, it is clear that China has been wrong-footed.

What is most impressive about the past few weeks though is how relatively calm and passive the Chinese authorities have been.

Over the past couple years, domestic markets for all assets have been characterized by a high level of official micro-interference: calls made to investors telling them not to sell holdings, high-profile state media warnings against spreading rumors or selling down stocks, ad hoc measures to limit certain types of trading and of course, government-organized share purchases and selling of U.S. dollars to move prices and shape sentiment, all done in the name of limiting financial risks and ensuring stability.

Investors in Chinese markets have thus come to expect the regulators to take a proactive role so where have they been of late?

The market weakness over the past few months could be seen as an imported correction, stemming from the U.S.-China trade conflict and the dollar's strength. As such, perhaps the authorities did not feel the need to immediately respond.

But the response has now begun. On Aug. 3, the People's Bank of China said it would reinstate a requirement that banks providing currency forwards to short the yuan put 20% of the funds into reserve. Media reports suggested the central bank had sold dollars as well.

The moves show the authorities have no intention of letting market forces take over and remain ready to act when red lines are crossed. The 6.9 yuan/dollar exchange rate level appears to be a red line, at least for the moment, but it would be hard to imagine this level not being tested again in the coming weeks.

The reserve requirement on forwards has been used before in times of currency weakness but had been cut to zero last September. The currency initially strengthened last Monday back to 6.81 but weakened again over the following days.

Moves to support the stock market have so far been limited. The China Securities Regulatory Commission issued a statement on Aug. 8 that was more notable for what it did not say than what it did.

Gone from the agency's previous agenda was any mention of China depository receipts, the tool that had been heralded as the great innovation that would this year give domestic investors a direct route to invest in overseas-listed technology companies like Alibaba Group Holding and Tencent Holdings. Instead, the regulator talked about revising rules for share buybacks and widening access for foreign investors through the Qualified Foreign Institutional Investor and Renminbi Qualified Foreign Institutional Investor programs.

China's stock markets remain highly leveraged. While in 2015 the key issue was margin financing, this time it is shareholdings pledged as collateral for loans.

Large shareholders of domestically listed companies have put about 5 trillion yuan ($725 billion) worth of shares with their brokers as collateral for loans. A falling market will eventually lead to margin calls on these positions, meaning that the pledged shares could be sold to pay off the borrowings. This would further push down stock prices.

Like the PBOC, the CSRC will likely go to its old playbook to support the market, with ominous statements about clamping down on negative news and rumors, calls warning institutional investors against cutting their holdings and direct state buying of stock. Approvals for initial public offerings and secondary placements could also be held up once again, though with deleveraging efforts biting, equity financing is a key source of funds for private companies.

These would all be stopgap measures, but slowing the speed on the market's correction would be more important than the market index's ultimate level. What worries the authorities the most would be a sharp, sudden re-pricing of assets.

It is easy to lament market interference but this is the reality of Chinese markets. The failure to bring fundamental change over the past few years has left regulators with no good options.

Doing nothing in a market meltdown would not be an option; the authorities will have to do something. They are understandably concerned that the free market approach of allowing prices to fall and letting investors bear the full risk on their own investments could have spillover for other companies through the pledged shares as well as impact wider economic sentiment.

To step in now, as the regulators are starting to do, would only reinforce the moral hazard in the market and distort prices even more. As previous attempts to prop up the market have shown, there is only so much the regulator can do.

Slowing down the market's descent and perhaps curbing the most speculative of investors will not provide support for long. The authorities' moves did arrest the market's decline back in 2015 but the massive intervention only postponed price corrections, something now being felt. A real capitulation then could have addressed the warping of the market. The roots of today's problems go back to the mismanagement of the 2015 bubble.

The PBOC's action on forwards should remind investors that even when the authorities loosen controls as when the central bank eliminated the reserve requirement last year, this is never a promise not to reinstate such measures.

Opening and reform will always be on Chinese terms. The authorities reserve the right to take action and intervene as they see fit. Count on it.

Fraser Howie is co-author of "Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise." He has worked in China's capital markets since 1992.

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