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The fears haunting China's markets

Last week's equity tumble shows instability will persist without serious economic reform

| China
Economic reforms are needed to keep investor uncertainty from resurfacing.   © Reuters

Barely a month ago, the MSCI index company gushed that China's inclusion in the premier emerging-market stock benchmark could "change the face" of investing.

And it has. Just not how MSCI expected.

Now, the face in question is the one MSCI is trying to save as China's A-shares seem to have proved themselves to be unready for prime time. Shanghai stocks have tumbled about 13% since MSCI added them on June 1 amid worries about economic growth and Donald Trump's trade war. Only equity markets in Argentina and Namibia -- not the company Chinese President Xi Jinping wants to keep -- fared worse.

Yet the A-shares plunge is, more than investors admit, a function of the policies of China's president -- policies fooling investors to load up on mainland shares before their time.

Call it the cult of China's inevitable triumph. The argument goes that investors only need to wait before they reap the rewards for backing what will, sooner or later, become the world's largest economy.

But, in the here and now, the case for A-shares is still circumstantial at best. It is not based on sound corporate governance practices. In particular, it is sadly becoming ever harder to discern in China where the public sector ends and the private sector begins.

The investment logic is not based on transparency. Under Xi, China's financial realm has grown ever more opaque. Take Beijing's push to allow anonymous bidding in its $11 trillion distressed debt market. The collective response from analysts: Huh?!?!?!?

Xi has tightened the noose around the internet and the press. Fears of crossing a leader who might be around for decades, has foreign journalists, investment banks and academics pulling punches.

Those efforts have spilled over into Hong Kong, once a capitalist mecca. Xi's party favors vague anti-sedition laws that would turn self-censorship up to 11 on a scale of 10. It wants to allow Hong Kong company directors to conceal personal data -- the home addresses and identification numbers needed to discern who owns what and why. At the same time, Xi has expanded equity market links between Shanghai, Shenzhen and Hong Kong.

Those stock-connect schemes allow China to offer the veneer of opening up to global markets, while also allowing mainland companies to tap foreign capital. The dark rise is that it is increasing the outside world's exposure to an erratic financial system. If such moves are aimed at buttressing China's global image, they are backfiring at the moment.

Yes, the cult of Chinese inevitability is a tantalizing and seductive phenomenon. China, the bulls claim, is run by geniuses. Its pockets are endlessly deep. The siren call of 1.4 billion consumers determined to become rich trumps all risks. If you doubt China's macro story, you just do not get it. This ethos will sound eerily familiar to investors who lost big when the dot-com's crashed in 2000. China is the economic equivalent of sex: it sells, no matter what.

Only, China's micro deficiencies are marring the macro narrative. The biggest concern: Mountains of debt at the corporate and local-government levels bumping up against a national debt-to-GDP ratio approaching 300%. Beijing's tumbling currency reminds investors that Xi is not as omnipotent as they believed. It reminds them, too, that defaults on dollar-denominated debt could shake markets at any moment. Mostly, though, it reminds markets that the summer of 2015 never really ended. The cracks that then slammed Shanghai shares and sent a whiff of crisis Beijing's way did not disappear any more than Europe's debt troubles. They merely went dormant, only to reemerge as U.S. President Trump's tariffs imperil Chinese growth.

Is China about to crash? Doubtful. Xi may be the strongest Chinese leader in generations and maintaining legitimacy requires rapid gross domestic product growth and financial stability. The moment incomes stall, state-owned enterprises lining the pockets of many Communist Party bigwigs falter and property prices crater, Xi will be looking over his shoulder.

Nor does Xi want to take any chances. Last week, a leaked report by the National Institution for Finance & Development think tank raised the specter of a "financial panic." As detailed by Bloomberg News, it warned of the knock-on effects from Trump's tariffs, suggesting members of Beijing's elite fear the worst -- bond defaults, credit dislocations and the recent stock plunge deepening.

Expect Xi to throw the full weight of his government at Shanghai shortsellers, just as in 2015. Back then, Beijing bought shares, cut interest rates, suspended IPOs, loosened margin requirements, allowed punters to use homes as collateral and even switched off entire sectors of the market. It ran a propaganda campaign, urging mainlanders to buy the market out of patriotism. Things stabilized, giving investors confidence to go long again.

But none of those steps, or any since, sufficiently curbed shadow-banking excesses. They did not go far enough to internationalize corporate practices, scale back the influence of SOEs or wean China Inc. off its reliance on easy People's Bank of China financing. They did not pull Beijing's tentacles out of vital sectors or slash the role of exports now under threat from Washington.

The trillions of dollars Xi spends on his "Made in China 2025" and Belt and Road initiatives matter little if the system underpinning those ambitions cracks. This disconnect is at the root of global investors' exposure to China's troubles. The grandiosity of Xi's aspirations fuels an inevitability myth he has yet to prove.

Ominously, Xi's team seemed to view inclusion in indexes like MSCI's as a reform all on their own. A Good Housekeeping seal of approval that Beijing's work to recalibrate growth engines and rein in debt is working.

Last week's nearly $2 trillion rout in emerging market stocks tells a very different story. Odds are, this is not a crisis moment for emerging markets broadly. Recent volatility aside, Asia has monetary and fiscal latitude to fend off turmoil. National balance sheets are generally healthier than in 2013 during the Federal Reserve "taper tantrum." Healthy growth rates, meantime, offer some cushion.

Mercifully, too, MSCI has so far allocated a 5% weighting to A-shares -- instead of the full 18% China merits -- limiting the fallout. But the ferocity of the selloff complicates Xi's efforts to encourage foreign inflows and convince speculators that the next global crisis will not come from China.

Already in bear-market mode, the Shanghai Composite Index has not seen such a big ratio of sellers to buyers since 2013. Average daily turnover, meantime, is the lowest since summer 2014, a sign buyers are not running to China's defense. Such dynamics are hitting international retirement plans, endowments and exchange-traded funds tracking emerging-market indexes. Punters betting on the mainland via Hong Kong are also smarting from buyer's remorse.

That 2015 feeling in the air might not dissipate anytime soon. Expect the PBOC to pump as much liquidity into markets as needed. Expect, too, that Xi's team will take a "kitchen sink" approach to restoring calm. That idiomatic phrase was uttered early and often in 2015, as Beijing threw everything it could at a cascading market.

But Xi must treat the underlying causes of China's chaos. That means making institutions more transparent, SOEs less dominant, GDP less reliant on excessive credit growth and smokestack industries. It is not enough to treat the symptoms. The only inevitability is that China will remain wobbly until it does the work needed to craft a stable economy.

William Pesek is an award-winning Tokyo-based journalist and author of "Japanization: What the World Can Learn from Japan's Lost Decades." He was given the 2018 prize for excellence in opinion writing by the Society of Publishers in Asia, for his work for the Nikkei Asian Review.

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