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2015: China's Lehman Moment

September 14, 2018

 

2008 witnessed the US financial system imploding and the world economy plunging into a deep recession.  The blame for this over-heating of the economic system was placed on investor over-confidence egged on by the failure of American government to regulate and supervise trading platforms. However, seven years later, in 2015, China observed that stringent regulation of the financial industry could also lead to equally large market bubbles.

 

The commonality between 2008 and 2015 is that in both US and China, it was the state which ostensibly provided the stimulus that funded rash decision making. Post the September 11 attacks, the US Federal Reserve needed a route to enhance spending – in an economy already recovering from the dotcom bust. Alan Greenspan, the then Fed Chairman, moved to ease monetary policy by lowering interest rates (the rate at which banks could borrow from the Fed) to 1%.  This low rate of interest prompted investors to seek other avenues to invest their money as T-bills became less attractive – they found solace in mortgage backed securities, sheets of paper which promised the buyer a share over profits from home loans, which rarely ever defaulted. MBS, as they began to be referred to, were the next big thing. Investors would buy them for large premiums over the underlying property loans, with the hope of selling them for a higher price to another investor. MBS emerged as the most lucrative alternative and American investors became heavily leveraged to buy varying qualities of CDOs – put simply, they took more loans to buy, well, loans, and sell it to someone who was doing the same thing, making some profit in the process. Things would eventually collapse when there was no one with the appetite to take more loans. All this because the US Fed decided to make it cheaper for investors to get money. In contract to the US Fed though, the Chinese state played a more active part in the 2015 stock market crash.

 

 

China opened trading for foreigners on the Shanghai Composite Stock Exchange in 2014, for the first time – the catch, investments had to be routed through brokers with connections in both Hong Kong and Shanghai, creating a massive information void. In addition, the Communist Party mustered the highly efficient state propaganda machinery to promote domestic retail participation in the stock market, stories about Chinese individuals making it big in the stock market were let loose. The entire charade was to ensure sale of state-owned junk assets (largely worthless shares), at highly over-priced rates through a mix of disinformation, created euphoria and artificial scarcity. For some reason or another, margin training – the art of realising that losses are becoming unmanageable and thereby closing the position to reduce damage – was not enforced by the Chinese state. Instead, the government was happy to see people invest vast sums on largely worthless paper, using borrowed funds. A large number of domestic Chinese investors, lured in by government propaganda, were unaware and began trading without paying heed to fundamentals. These developments resulted in inflation of share prices to unsustainable levels. And like in the US, once people ran out of the ability to take on more debt, sellers became desperate to offload their positions so that they could get out of debt. In June 2015, the tipping point emerged when the bubble burst and 3 trillion dollars (almost 1.5 times the size of India’s GDP) were wiped off Chinese markets, sending shockwaves across the world.

 

Source: CNN Money (2015)

 

While both the US and China witnessed a creation of perverse incentives along with greedy investors taking myopic decisions. The eventual collapse of the markets was due to some stark differences in the policies leading upto them, and in the aftermath of the crises.

 

Post the collapse of 2008, the US government provided emergency loans to the banks to prevent fundamentally sound banks from collapsing due cascading of panic among investors. A thorough study of balance sheets of all major banks on Wall Street was conducted and funds were made available to those in need, while financially sound firms (like Bank of America) were encouraged to buy out vulnerable one’s (such as Merrill Lynch) – thereby facilitating a more stable banking system. Finally, United States enacted the Dodd-Frank Law which prevented excessive risk taking by banks and hedge funds. As the American financial system moved towards transparency in the wake of a crisis, the Chinese system moved away from it. China prohibited any executive or investor holding more than 5% of the company, from selling its shares. It even stopped trading completely in shares of certain companies, while restricting future IPOs. Measures which were intended to eliminate uncertainties that paralysed trading among institutions, ended up eroding investor confidence as they highlighted the short-sightedness of the Chinese government. Over the next few weeks, the stock market faced a series of shocks and the Shanghai Composite stabilized only by 2016, by which time trillions more had been lost. But most importantly, the exchange’s reputation took a hit, and till date, investors are wary of using the index as a means of routing their investments into China. More importantly, it has prompted several Chinese firms (such as Alibaba), to list at exchanges in the US instead of Shanghai.

 

 

The lesson from the two countries is that certain classes of investors are always on the lookout for manipulating the financial system, when the regulators fail to recognize the signs, a catastrophe is inevitable. In response to these crises, the answer cannot be prohibition of decision making by investors – which will only lead to further hardship. The answer lies in creating an environment of stability where those looking to close their positions can do so without destabilizing the system.  Most importantly, even before a crisis begins, it is important to regulate markets in a balanced manner. History shows that while under-regulation of the financial markets is disastrous, their over regulation can be explosive too. Thus, in an ideal world one would prefer the correct amount of regulation, should a crisis hit home, its always better to bite the bullet on aesthetics and bail out systemically important firms rather than restrict market freedom and render a crisis unsolvable. 

 

Article has been updated for accuracy. 

About the Author

Samridhi Vij Masters in Economics from the Delhi School of Economics, India. She is an accomplished research scholar in the domain of socio-economic and developmental issues. She has been associated with UNICEF, during which time she published two papers concerning India's Maternity Benefit Programme and the National Social Assistance Programme. Samridhi has also conducted research and authored parts of a paper published by the National Commission for Protection of Child Rights, India on rehabilitating juvenile offenders. At Polemics & Pedantics, Samridhi will be providing an analysis of subaltern politics in India.

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