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Stock markets are plummeting in China, indicative of a vicious deleveraging cycle as the real estate woes worsen. What will they do to stem the bleeding?

In spite of Beijing's recent efforts to boost confidence in the economy and halt a prolonged decline in the stock market, which has resulted in a loss of $7 trillion in value over three years, investors continue to sprint for the exits. 

Last week, the Shanghai Composite index experienced its most significant weekly decline since October 2018, dropping by 6.2%, while the Shenzhen Component index recorded its most substantial decrease in three years with an 8.1% loss. Both indexes had witnessed losses of more than 8% and 15% each since the beginning of the year.

On January 29th, a Hong Kong court announced the liquidation of Evergrande, the globe's most indebted property developer and a symbol of the Chinese real estate crisis. Instead of offering closure, this order spread new fears about the fate of the real estate business and other financially troubled developers.

I wrote extensively about the Chinese real estate crisis in December in a paid research piece, especially targeting the risks to the financial sector:

_“The major concern revolves around the ripple effect on China's "shadow banking sector," an enigmatic term to describe institutions that act as banks and make up a significant part of its financial realm. This industry, valued around $3 trillion at its most conservative estimate and potentially reaching $12 trillion when factoring in asset management products and consumer loans, has garnered attention lately due to the default of two major entities. 

These players, heavily involved in the property market, have struggled to fulfill their obligations to investors. 

Last month, Zhongzhi Enterprise Group, a prominent financial conglomerate in the country (one of the shadow banks), declared insolvency following defaults on numerous investment products. This move has prompted a criminal investigation by the police targeting the company. In other news, two weeks after Zhongzhi's financial turmoil, China's state media disclosed that another shadow bank, Wanxiang Trust, an investment and asset management firm based in Hangzhou, postponed payments amounting to several hundred million dollars across various investment products.”_

The deleveraging that was occurring in the real estate markets and the shadow banking system appears to be spreading to the traditional equities markets. The CSI 1000 index in China has experienced an 8% decline today and a staggering 30% decrease in the first month of 2024. In the past 10 days alone, the index has plummeted by a substantial 21%. The CSI 300 benchmark dropped by as much as 1.4%, marking its most significant weekly loss since 2022. 

The crisis has continued despite new restrictions on lending and short stocks, which were implemented in hopes of slowing the rapid decline in the equities markets. 13 hours ago, 30% of all stocks in the CSI 1000 index were halted as the market rout deepened. 

On Sunday, the China Securities Regulatory Commission pledged to curb volatility by directing additional medium- and long-term funds into the market. Additionally, the commission stated its intention to clamp down on illegal practices such as malicious short selling and insider trading. However, this appeared to do little to slow the spreading panic.

More drastic measures may even be at hand- one academic at a government policy center stated that the country should set up a stock market stabilization fund to buy up distressed equities, filling the fund with 10T yuan ($1.4T) or more! 

All of this comes on the back of another negative CPI print for the Chinese in December, where the index fell 0.3% YoY. The Producer Price Index (PPI) experienced a 2.7% decrease following a 3% decline in November, marking the 15th consecutive month of declines.

The slowing Chinese economy may be a canary in the coal mine to other financial markets that the effects of the fastest rate hiking cycle in recent memory (with record global debt levels) have not been fully felt yet.

The speed of this downturn may be shocking to some, but I am relatively unsurprised. The Chinese stock market is littered with frauds, scams, pump and dumps, and blatant corruption. Officials are paid to look the other way, auditors don’t care about the accuracy of reports, and due diligence is essentially a non-starter. I was awakened to the depth of the problems in China in 2018 when watching The China Hustle, a documentary on the fraudulent listing of Chinese equities on U.S. exchanges and how retail investors were exploited.

In contrast to many documentaries on finance, economics, and fraud, "The China Hustle" is accessible to mainstream viewers with limited knowledge of stock markets and investments. The film effectively breaks down complex concepts, straightforwardly presenting each step with clear explanations and demonstrations of the processes and outcomes. 

Most importantly, it features real individuals who experienced the fraud, some who suffered losses, others who profited, and some who, despite having benefited, are now actively working to expose and end such practices, even if it means putting an end to their own profits.

I haven’t watched the film in years, but from what I remember, it tells the story of a fund manager who begins to investigate several different Chinese equities that got listed on NYSE. He begins to realize that the companies are complete frauds, and are used to extract wealth from U.S. investors including retired seniors. It was a fascinating watch, and one I highly recommend- but the main gist of the story was that nobody was prosecuted for these crimes.

In China, there is a categorical difference between domestic investors and foreigners. If a board of a company is caught manipulating financials and lying to other (wealthy) Chinese, the regulators, if properly incentivized by the victims, will come after the perpetrators. Typically, they will ask for tit-for-tat; meaning if they prosecute the board members the regulators themselves ask for something in return, like the placement of their son or daughter in a prominent school. However, if the investors are poor, and even more so if they are foreign- then nothing will be done. 

No arrests. No interrogation. No investigation to speak of at all. 

This led me to believe that the Chinese stock market could be a wholesale fraud- if regulators were this blind in these cases that were connected to the foreign markets, where an argument could be made for cracking down in order to appease influential American investors, then how much worse was the auditing for blue-chip Chinese stocks listed on their own exchanges?

The answer seems to be much worse. Given the absolutely abysmal performance of the main indexes such as the SSE Composite, almost no new money is flowing into Chinese equities, either from the mainland or elsewhere.

If you look closely on the graph, Chinese equities are trading at the same place they were in November 2014, 10 years ago. If you compare this to the SPY index in the U.S., this means that U.S. markets would have to fall 60% relative to China to get back down to the level seen that month a decade ago.

Now, is this indicative of an overbought U.S. market? Partly perhaps- but the absence of fundamental growth is a worrying sign that the Chinese themselves know that their equities are nowhere near a fundamental representation of the growth in their own economy.

This article was originally written on The Dollar End Game.

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Recent events in China have highlighted the economic challenges facing the country. A series of purges among top officials, ongoing efforts to stabilize a volatile stock market, and the struggle to maintain a fragile banking system all point toward a government grappling with significant financial turmoil. This article examines the available data to understand the depth of China’s economic issues and the impact of the government's responses.

Governmental Purges and Market Instability

The dismissal of Yi Huiman, head of China's main securities regulator, mirrors the increasing number of purges occurring within China's political landscape. These purges are seen as a response to a plummeting stock market, which has experienced a $5 trillion sell-off. Authorities have been attempting to intervene in the market, urging institutional investors to buy stocks in hopes of halting the decline. However, these measures appear to have had minimal impact, as investor confidence remains low and the stock market continues to exhibit instability.

Banking System Concerns

China's banking system is currently under considerable stress. Efforts by the People's Bank of China (PBOC) to provide liquidity have escalated, as evidenced by their balance sheet expansion in the latter months of the previous year. Despite these efforts, the banking system remains fragile, suggesting that the government's interventions are not effectively addressing the underlying issues.

Macroeconomic Indicators

China's macroeconomic statistics are difficult to assess due to the timing of the Golden Week holiday, which affects the reporting schedule for key economic indicators. However, available data on consumer and producer prices for January suggests persistent economic weakness. The consumer price index's year-over-year change marked a 0.8% decrease, and producer prices continued to show deflationary trends, indicating overcapacity and reduced demand.

PBOC's Measures

The PBOC has taken several steps to address the financial challenges. The balance sheet expansion, particularly through claims on other depository corporations and short-term lending facilities, reflects substantial efforts to provide liquidity to banks. Moreover, the unusual cut in the reserve requirement ratio (RRR) in late January aimed to inject further liquidity into the market. Despite these actions, the central bank's initiatives have not translated into increased lending or economic stimulation.

Stock Market and CPI Analysis

The Shanghai stock index has struggled to recover from its recent lows, despite the RRR cut and other government interventions. Additionally, the consumer price index indicates ongoing deflationary pressures, especially in the retail sales and consumer spending sectors. Producer prices also continue to fall, reflecting the impact of a global trade recession and internal economic challenges.

Conclusion

The Chinese government, particularly the PBOC, has been proactive in its attempts to stabilize the economy. However, the data indicates that these measures have not had the desired effect. The persistence of deflationary pressures, a lack of investor confidence, and a fragile banking system suggest that China's economic troubles are deep-seated and may pose risks beyond its borders. As the government continues to navigate these challenges, the potential for a "hard landing" scenario becomes increasingly plausible. The global implications of China's economic distress will be closely monitored as the situation evolves.

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In an unprecedented move that could mark the end of the world's most indebted developer, the Hong Kong High Court has ordered the liquidation of China Evergrande Group, a company staggering under the weight of over $300 billion in debt. Justice Leonard Chen's decision came as a long-anticipated response to the lack of progress between Evergrande and its creditors.

The embattled property giant, which has been a cornerstone of China's booming real estate sector, has seen its restructuring plan disintegrate, leaving offshore creditors with approximately $20 billion of debt hanging in the balance. The assets under consideration for the liquidation process include Evergrande's listed China Evergrande unit, its electric vehicle division that has yet to produce a single car, and its services unit.

Later in today, Justice Linda Chen is expected to explain her rationale behind the liquidation order and appoint a provisional liquidator, setting the stage for what is likely to be a complex and protracted unwinding of the conglomerate's numerous assets.

With Evergrande's stock already suspended from trading in the Hong Kong market, the focus shifts to the appointment of the liquidator and whether this entity will pursue the company's onshore assets in mainland China—a task that, according to analysts, could span years due to the sheer volume of projects and units involved.

The fall of Evergrande is a bellwether for China's property sector, which is already experiencing a crisis of confidence. The liquidation of such a significant player is expected to further exacerbate the declining cycle of property sales, undermining the confidence of homebuyers and potentially leading to broader economic repercussions for the country's real estate market and beyond.

As the story continues to unfold, the global financial community watches with bated breath, recognizing the potential for Evergrande's collapse to send ripples through the international markets.

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Introduction to China's Economic Status

China, the world's second-largest economy, is facing significant economic headwinds. Recent developments suggest a heightened level of concern from the Chinese government over the economic challenges facing the country. The People's Bank of China (PBOC) has announced new emergency measures which include a cut to the reserve requirement ratio (RRR) in a bid to stabilize the situation.

PBOC's RRR Cut

On February 5, the PBOC is set to cut to the RRR by 50 basis points. This move is notable for two reasons: it is double the typical 25 basis point cut, and it deviates from the usual process of signaling such a move through the State Council before a formal announcement by the PBOC.

Analysis of the RRR Cut

The RRR cut is designed to allow Chinese banks to use more of their cash holdings rather than keep it in reserve. The intention is to encourage banks to lend more and stimulate the economy. However, historical patterns suggest that RRR cuts are typically associated with periods of economic distress and are not necessarily stimulative. These cuts have occurred during challenging times, such as the euro dollar cycles of 2015-2016 and 2018-2019, and more recently in 2022.

A Bloomberg quote suggests that announcing an RRR cut in advance implies a lack of other effective tools to address market turbulence. This move is seen as a response to a declining stock market and broader economic deterioration.

PBOC's Additional Comments

PBOC Governor Pan Gongsheng also indicated future plans to assist "high quality" real estate developers with funding. This statement suggests that the real estate issues may be affecting more stable developers and not just those previously in distress.

Market Intervention Strategies

Chinese authorities are reportedly planning to mobilize substantial funds from both offshore and local sources to stabilize the stock market. This includes a proposed 2 trillion yuan from state-owned enterprise accounts and at least 300 billion yuan through domestic channels. Measures such as a short-selling ban on Chinese stocks also indicate a growing unease from policymakers.

The Seriousness of China's Economic Situation

Assessing the situation on a scale of calm to disorderly unwind, the recent actions by Chinese authorities suggest a shift from moderate concern to a higher level of alert, potentially moving from a level five to a six or seven, given the lack of economic response to stimulus efforts and the real estate market's difficulties.

Indicators to Watch

Key indicators for assessing the seriousness of China's economic challenges include the Chinese yuan's exchange value, repo rates, and the Shibor (Shanghai Interbank Offered Rate). A weakening yuan, increasing repo rates, and an elevated three-month Shibor rate could signal further liquidity concerns and risk aversion among banks.

Conclusion

The PBOC's recent RRR cut and other market interventions indicate a heightened state of concern regarding China's economic trajectory. While still a risk rather than a certainty, there is a realistic possibility of a disorderly unwind that the Chinese authorities are trying to prevent. Observers will continue to monitor financial indicators, government responses, and the real economy for signs of either stabilization or further deterioration. The implications are significant not only for China but for global trade, financial markets, and geopolitical stability.

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In an alarming financial downturn, China's stock market is experiencing a significant collapse, causing widespread concern within Beijing's political echelons. The Shanghai index, China’s benchmark index, plummeted by 5% last week, leading to a staggering loss of $500 billion in Chinese corporate equity. This precipitous fall has contributed to a 25% drop over the past two years, starkly contrasting with the global financial landscape where U.S. stocks rose by 10%, British stocks remained stable, and Japanese stocks saw an increase of nearly a third.

The performance of Chinese stocks is a troubling outlier on the world stage. Since 2007, Chinese stocks have failed to show any growth, marking 17 years of stagnation—a period that coincides with President Xi Jinping's tenure and his government's handling of the economy. Under Xi's leadership, the Chinese economy has suffered from government mismanagement, politicized subsidies, and authoritarian interventions, casting doubt on the nation's economic stability.

The recent nosedive has sent shockwaves through Beijing, with officials acutely aware of the potentially catastrophic impact on Chinese households and the country's deeply indebted financial system. China's debt crisis looms large, with debts surpassing 300% of its GDP—an equivalent of nearly $80 trillion by U.S. standards. A deflationary spiral, driven by overcapacity in sectors like manufacturing and housing, exacerbates the problem by effectively increasing the real burden of debt.

In response to the crisis, China's State Council has initiated an all-hands-on-deck approach to stave off further market collapse. Measures have included tax tweaks, bans on short sales, and infusions of capital into state-linked firms. Reports suggest a potential 2 trillion yuan ($300 billion) rescue package, reminiscent of the 2015 bailout. However, skepticism abounds regarding the effectiveness of these interventions due to the underlying weaknesses in China's growth model, which has been propped up by government spending, state-supported exporters, and a faltering housing market.

This economic turmoil has prompted a shift toward a nationalized stock market, mirroring the broader trend of an increasingly state-controlled economy. As growth stagnates and President Xi's authoritarian policies deter investors, capital is flowing out of China to emerging markets like Indonesia, Vietnam, and even Mexico, while the U.S. struggles to attract foreign investment due to its own domestic challenges.

The unfolding situation in China could present an opportunity for the United States, particularly if there is a shift in domestic policy following the 2024 presidential election. With potential changes in the political landscape, America could capitalize on China's economic distress—if it manages to address its internal manufacturing and policy constraints.

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Introduction

The interplay between global asset prices and liquidity is a critical area of focus for investors and policymakers alike. Understanding the dynamics that drive these financial variables provides insight into the broader economic climate. The above video by Luke Gromen examines whether global asset prices can decline amidst increasing global liquidity, the impact of oil sales on currency valuations, and the implications of shifts in monetary and fiscal policy.

Global Liquidity and Asset Prices

One of the fundamental questions raised regards the possibility of global asset prices decreasing while global liquidity is on the rise. Historical trends suggest that as liquidity increases, asset prices tend to rise due to the availability of more capital to invest. This increased demand for assets typically inflates prices. However, the sensitivity of different assets to liquidity changes can vary. For instance, Bitcoin has been cited as a particularly sensitive indicator of liquidity changes, often reacting positively to increases in liquidity.

Currency Dynamics and Oil Transactions

The currency market dynamics are influenced by numerous factors, including how commodities like oil are transacted. When Saudi Arabia sells oil to China in renminbi (RMB) instead of US dollars, it ostensibly reduces the demand for dollars from the Saudis. However, given the entrenched nature of the dollar in global finance, particularly through the offshore dollar-denominated debt markets, even a marginal shift can lead to a strengthening of the dollar. This is because a reduction in the supply of dollars to meet the persistent demand can drive up the value of the dollar. Conversely, a surplus of RMB, with comparatively less demand, could lead to a weaker RMB.

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Implications for Gold and Treasury Demand

The shift away from pricing oil exclusively in dollars has ramifications for gold and US Treasuries. As central banks diversify their reserves away from US Treasuries and towards gold, the demand for the latter increases. This trend has been observed over the past decade. In the long term, the move away from dollar-centric oil transactions could diminish the demand for US Treasuries, which, in turn, could be negative for the dollar.

Inflation, Deflation, and Interest Rates

The prospect of a return to a deflationary environment versus the potential for long rates to surpass 5% is a critical issue. Given the current fiscal landscape in the United States, it is argued that neither deflation nor excessively high long-term interest rates are sustainable. The fiscal situation may necessitate a period of secular inflation with persistent negative real interest rates. This would have a significant impact on long-term bond portfolios, which could face losses either nominally or in real terms adjusted for inflation.

Legal Constraints and Treasury Management

Questions regarding legal limitations on the proportion of short-term to long-term debt that the US Treasury can issue have been raised. While there may be legal frameworks in place, historical precedence suggests that such regulations can be amended if deemed necessary by policymakers, implying that these constraints may be more procedural than absolute.

Peak Cheap Oil Debate

Finally, the discussion on whether the era of "peak cheap oil" has ended and if we have entered a time of abundance requires careful consideration. While some argue that technological advancements and new supply sources are mitigating scarcity concerns, others maintain that the economics of oil extraction still point to a world where cheap, easily accessible oil is becoming scarcer. This has implications for energy pricing in various currencies and the relative cost of oil in dollar terms versus gold.

Conclusion

In summary, the relationship between global liquidity and asset prices is complex and multifaceted. Currency valuations, particularly the US dollar's status in global markets, play a significant role in these dynamics. The interplay between fiscal and monetary policy, commodity pricing, and legal frameworks all contribute to the evolving economic landscape. Understanding these interconnected elements is essential for navigating the global financial system.