Forget Greece the Economic Story is China’s Stock Freefall

For all the press that’s focusing on tiny Greece and its economic woes, my advice is to forget about Greece…it’s China whose stock market in freefall and that’s the real economic calamity waiting to happen.Cartoon china

And as usual, the U.S. media is missing the real story when it comes to possible economic calamity.

Yes, in Europe, a Greek referendum this Sunday essentially told Germany and France to take their high interest, rife-with austerity conditioned loans and stick them where the sun never shines. Whether the country will remain in the Eurozone, remains to be seen, but my guess is that the IMF (International Monetary Fund) has had enough.

The resulting consequences whether they do or don’t, could be disastrous for the eurozone’s financial clout, but my feeling is that it will be up to the northern European countries (read Germany) to decide whether or not they’ve wrung every last euro out of Greece, Spain, Portugal and Ireland.

Meanwhile, back in the U.S., the governor of Puerto Rico claimed last week that the island would be unable to pay off its debts, raising unsettling questions about the health of American municipal bonds.

But the season’s biggest economic crisis is occurring in Asia, (and is being typically ignored in the U.S. media) where shares in China’s two major stock exchanges have sunk like the Titanic in the past three weeks. Since June 12, the Shanghai stock exchange has lost 24 percent of its value, while the damage in the southern city of Shenzhen has been even greater at 30 percent. The tumble has already wiped out more than $2.4 trillion in wealth—a figure roughly 10 times the size of Greece’s entire economy.

Over 90 million people in China have invested in equities—a number greater than the total membership in the Chinese Communist Party.

When will pseudo capitalists realize that one thing and only one thing will sustain a business, a government or a country….demand for goods and services? Not stock markets, or tax cuts, or enriching the 1%.

Without a strong middle class, making enough income over a sustained length of time that they feel confident that they can afford to spend their discretionary, excess income on things other than necessities, there will never be a full recovery. Never.

Fearing another steep fall in the market leading to further losses, the Chinese government has taken action. On Saturday, the country’s largest brokerage firms agreed to establish a fund worth 120 billion yuan ($19.4 billion) to buy shares in the largest companies listed in the index. Beijing has also lowered interest rates, relaxed restrictions on buying stocks with borrowed money, and imposed a moratorium on initial public offerings. The country has even relied on propaganda to encourage the public to hold onto their shares for patriotic reasons.

The recent fall in the Chinese stock market followed an extraordinary bull period in which the Shanghai composite grew by 149 percent this year through June 12. The boom was fueled by retail punters relatively new to investing—according to the Financial Timesmore than 12 millionnew accounts were opened on the stock exchange in May alone. Once dominated by elites, the stock market increasingly has become a vehicle for China’s emerging middle class. Two thirds of households who opened accounts in the first quarter of 2015 didn’t even finish high school. Equity market fever has spread to China’s universities, where 31 percent of the country’s college students have invested in a stock. Three quarters of them used money provided by their parents.

In recent years, Chinese people have generally plowed their excess savings into housing, but the uneven performance of the real estate market has spurred interest in other vehicles for domestic investment. (Because of strict capital controls, it’s very difficult for most Chinese people to move money out of the country.) Increasingly, more have turned to the stock market. According toBloomberg, over 90 million people in China have invested in equities—a number greater than the total membership in the Chinese Communist Party.

The recent dip in prices, then, affects the fortunes of a large number of people. Should those outside of China worry about it?

Perhaps not. For a heavily integrated global economy that’s now the world’s second largest, China’s stock markets are quite isolated. Foreign investors hold only two percent of all Chinese equities, and equities account for only around 5 percent of overall financing. China’s aggregate bank deposits—a staggering $21 trillion—also provides a buffer against major market fluctuations. And the long bull run that preceded June’s swoon has not faded entirely: The Shanghai Composite is still up 20 percent since January 1.

Nevertheless, such volatility in the world’s second largest equity market (by market capitalization) raises questions about the overall health of China’s economy. GDP grew by 7 percent in the first quarter of 2015, its weakest mark in six years, and stimulus measures adopted by the government have yet to reverse this slide. According to Ira Kalish, Chief Economist at Deloitte, China’s slowdown has already had consequences beyond its borders.

More than two dozen companies in China are postponing initial public offerings and security companies are pledging more than $19 billion for a fund to stabilize the country’s free-falling stock market.

The 28 companies, which had obtained permission from China’s securities watchdog for IPOs planned in Shanghai and Shenzhen, said they would postpone them due to recent market fluctuations and refund money already paid, the official Xinhua News agency announced late Saturday. That followed reports that regulators were asking companies to postpone the IPOs.

Twenty-one Chinese securities companies, in a joint statement released Saturday, said they would pledge no less than 120 billion yuan ($19.33 billion) to invest in Chinese stocks and funds. The securities companies also said they would continue to invest in the market as long the Shanghai Composite index, the Chinese equivalent of the Standard & Poor’s 500 index, remains below 4,500. It closed at 3,686 on Friday.

The statement was posted on the website of the Securities Association of China.

The Chinese stock market has been in free-fall for three weeks, losing 28 percent of its value since June 12. Despite the plunge, the market is up 79 percent in the last year. The drop has wiped out several trillion dollars in market value in a matter of weeks.

Even though China is the world’s second-largest economy, the Chinese stock market remains largely isolated. Foreign investors can only indirectly participate in the market through funds or through specialized brokerage services. Unlike the U.S. and European markets where institutional investors play a major role, the Chinese stock market is dominated by individual investors.

For months, state-owned media had encouraged ordinary Chinese to load up on shares. Many Chinese individual investors borrowed heavily to buy stocks — taking out so-called margin loans. And the rising stock prices encouraged companies to raise money by issuing shares and to use the proceeds to pay down debt.

Everyone knows the Chinese government is desperate to keep stocks from crashing. But this desperate?

The regulatory tweaks aimed at supporting equities included this shocker:

Homes are now acceptable collateral for borrowing to buy more stocks. Let that one sink in. China is so desperate for stock purchases that they’re literally encouraging families to put up their houses as collateral for the dangerous, uncertainty of, essentially, betting on horses

Perhaps the least of the too-many-to-list problems with this idea is that personal property is difficult to liquidate when assets crash. The biggest is that China is sowing the seeds of a third financial time bomb to match its debt and stock bubbles.

Ginning up shares with central bank liquidity and regulatory inducements, as China has already done, is a slippery slope. Tying the future of the nation’s housing sector to today’s stock mania is outright madness. Why bother letting banks churn out subprime debt instruments, as Wall Street did in the Bush years of the wild and wooly 2000s, when you can turn your entire economy into one?

Suppose some of the $4 trillion worth of debt amassed by local governments in recent years were to go sour (many already have, but China does transparency the way the GOP in the U.S. can only dream of). And suppose that volatility in interest rates spills over into Shanghai and Shenzhen shares, which is entirely possible, if not probable. That would throw one bubble into another, bursting both and triggering a third shakeout in the one Chinese asset market — home ownership — that’s not supposed to be a giant casino.

The good news is that many securities companies may resist betting the house on the market, or at least as much as they can in top-down Communist China. Why welcome such a risk-management nightmare in a nation that already has way too many ghost cities? The wording of China’s new rules — and its list of “other assets” that can be used as collateral — will force brokers to become “experts” in valuing everything from property, to antiques, to art.

The bad news is that the authorities in Beijing clearly are betting everything on a stock rally that’s just hasn’t come: Stocks just sustained their biggest three-week loss in more than two decades.

That’s in spite of moves last week to loosen margin lending, cut interest rates, reduce reserve requirements, and directed the state-run media to churn out “don’t-panic articles”. Over the weekend, the government even suspended initial public offerings and set up a market stabilization fund.

Margin traders, who increased their leveraged investments nine-fold in the last two years, to about $322 billion from $35.7 billion, have been rushing to close those positions for a record nine consecutive days. And the Shanghai Composite Index’s plunge below the symbolic 4,000 level signals even more selling. Further, a slide in iron-ore prices last week suggests that Chinese demand is slowing more sharply than the government is letting on.

All of this indicates that the government’s recent stimulus efforts aren’t working. At a time when Xi’s team should be strengthening China’s financial system, they’re just making it more fragile. What’s needed are decisive steps to shore up domestic demand, not more market froth.

Just as in the U.S., crazy strategies to get the PUBLIC to gamble more on the lottery-ball certainty of the stock market, won’t work any better than cutting taxes in an extended economic downturn. It’s not even “Bizarro-type Austerity”; it’s talking the middle class of the second largest economy in the world into gambling the roofs over their heads on a crashing market for the benefit of the stockholders who have squandered opportunities to spread even a modicum of the wealth around.

If this sounds like a sound strategy to you, you must be a part of the U.S. GOP who continues to get the white middle and lower income class to vote against its own interests while granting tax breaks to the 1% who stash their cash offshore and buy foreign-made luxury products while the middle class languishes in a slow, painful pool of economic quicksand.

Harvey Gold