September 1, 2015


China's Crisis Could Get a Lot Worse, Quickly : As stock prices fall, Beijing may end up bailing out much more than the markets. (DANIEL ALTMAN, SEPTEMBER 1, 2015, Foreign Policy)

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 United States Treasury notes.

China is already selling Treasuries from its reserves to stop the renminbi from plunging further, after the abortive devaluation that began on August 11 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.

Posted by at September 1, 2015 3:32 PM

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