China’s Exercise in Futility

At the moment, it appears the Chinese government has forestalled a full stock market meltdown.  To do so, the People’s Bank of China made direct purchases of stocks trading on the Shanghai Stock Exchange.  What type of chimera is this?

Obviously, this was a desperate measure that only pushes instabilities further out on their precarious perch.  For all is not well in China.  Like the stock market, the financial and economic fundamentals of the country are also out of whack.

Beijing’s policies of mass credit creation have enticed the Middle Kingdom’s corporations to borrow gobs of money.  Corporate debt in China has run up to $16.1 trillion.  This is the largest corporate debt pile in the world…and it appears to be breaking down.

The situation Chinese businesses find themselves is the unfavorable place where debts are rising while profits are fading.  Borrowing more money to increase production only exacerbates the problem.  Companies can’t make up for profit losses with higher volume.

Making matters more difficult is the economic structure of China.  Namely, the abundance of state-owned enterprises.  These companies are notoriously inefficient.  Still, they’re propped up so they can continue consuming credit at a loss.

Buyer of Last Resort

“Corporate China’s debts, at 160 percent of GDP, are twice that of the United States, having sharply deteriorated in the past five years,” a Thomson Reuters study of over 1,400 companies shows.  “And the debt mountain is set to climb 77 percent to $28.8 trillion over the next five years, credit rating agency Standard & Poor’s estimates.

“Beijing’s policy interventions affecting corporate credit have so far been mostly designed to address a different goal – supporting economic growth, which is set to fall to a 25-year low this year.  It has cut interest rates four times since November, reduced the level of reserves banks must hold and removed limits on how much of their deposits they can lend.  Though it wants more of that credit going to smaller companies and innovative areas of the economy, such measures are blunt instruments.

“‘When the credit taps are opened, risks rise that the money is going to ‘problematic’ companies or entities,’ said Louis Kuijs, RBS chief economist for Greater China.  “The effect of policy easing has been to reduce short-term interest costs, so lending for stock speculation has boomed, but there is little evidence loans are being used for profitable investment in the real economy, where long-term borrowing costs remain high, and banks are reluctant to take risks.”

Do you see the mess that has been made?  Shortsighted policies to juice the economy have turned the stock market into a roulette table.  Rather than free market forces efficiently allocating capital to profitable activities, easy credit policies have had the effect of funneling credit into stocks.

As we saw several weeks ago, the Shanghai Composite Index has been pushed to the extreme.  It has become highly unstable.  Now the People’s Bank of China has become the buyer of last resort.

China’s Exercise in Futility

China’s emergency intervention to prop up the stock market is but an exercise in futility.  As corporate profits continue to decline, it will become more and more difficult to keep the stock market inflated.  Bankruptcies, bailouts, and market panics will increase.

Unfortunately, these problems are not limited to China.  The United States, Europe, and Japan are also guilty of pumping credit into the economy to boost economic growth.  The Bank of Japan has also engaged in direct stock purchases.

Similarly, economic distortions have mounted, which could result in a painful adjustment period.  In fact, last month the governor of the Reserve Bank of India, Raghurman Rajan, told the London Business School that monetary policies of developed nations could be creating conditions similar to those that led to the Great Depression.

“I do worry that we are slowly slipping into the kind of problems that we had in the thirties in attempts to activate growth,” Rajan said.  “And, I think it’s a problem for the world.  It’s not just a problem for the industrial countries or emerging markets, now it’s a broader game.”

Of note, Rajan predicted the 2007-2008 financial crisis.  We think he’s on to something.

Sincerely,

MN Gordon
for Economic Prism

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