Hopping on a ‘treadmill to hell’

Call it irrational exuberance with Chinese characteristics. In August, a fascinating campaign unfolded in China’s state-run media, prodding citizens to pile into stocks. In one week alone that month, the official Xinhua News Agency ran at least eight articles touting the wonders and patriotic virtue of owning equities. The People’s Daily and local television channels joined in what analysts agreed was a Party-sponsored drive to bolster a sagging market.

The preceding few months had been a bloodbath. By the end of May 2014, the Shanghai Composite Index had lost $460 billion of market value in just three years. Presumably, officials figured that igniting a stock rally would boost confidence as President Xi Jinping recalibrated the economy away from excessive investment and debt and toward a “new normal” of slower growth. With foreign investors dubious, Beijing looked to households. The government augmented the PR blitz with regulatory sweeteners, reduced fees for trading and opening new accounts, and an orchestrated series of investor presentations by China’s biggest banks.

The charm offensive worked. By early September, the Shanghai Composite had surged to a 15-month high. That brought even more of China’s 1.4 billion people into the A-share market, pushing the index up another 40 percent in the past three months alone. Never mind that the economy is growing the slowest in 24 years, industrial profits are down 8 percent year-over-year, default risks are rising and overseas analysts are churning out apocalyptic crash narratives: Chinese are betting their savings on bourses that seem more like casinos than rational marketplaces. The run-up makes then-Federal Reserve head Alan Greenspan’s 1996 warning about a U.S. stock bubble seem quaint.

Does it matter that China’s stock rally has been artificially ginned up by the Party? No and yes.

No, because Beijing sees surging stocks as a tool to accomplish bigger goals. Encouraging a bubble could be a creative way to prevent a run on the yuan as Xi’s team manages a difficult deleveraging of the property sector. With multiple layers of shaky-looking dollar bonds at risk of default (developer Kaisa Group may soon be the first), Beijing wants a stable currency. In this context, the stock rally provides incentive for speculative money to stay in China.

Chinese leaders, too, could argue that they’re only following the example of Japan. Prime Minister Shinzo Abe can call strongarming the $1.1 trillion Government Pension Investment Fund to buy stocks a “reform,” but he’s really just trying to pump up equities and elevate confidence in the economy. Also, while moral hazards abound, China - armed with $3.8 trillion of currency reserves - can always prop up the market the way the Bank of Japan intervenes in bond markets. Given the danger that tens of thousands of small investors might lose their savings, Beijing won’t simply let this bubble implode.

On the other hand, the government is effectively promoting a massive pyramid scheme at odds with Xi’s pledge to rein in credit. Many investors are financing their stock purchases using opaque strategies, including so-called umbrella trusts that allow for more leverage than brokerage financing. In a rather scary piece yesterday, Bloomberg’s Justina Lee explored how investors use these vehicles to take even greater risks that add to China’s overall debt tally. Rather than shrinking, Moody’s estimates credit has skyrocketed to 71 percent of gross domestic product, up from 66 percent last year.

In other words, China is trying to deflate one bubble (exploding credit) by creating a new one (stocks) that may exacerbate the first by stealth. As bears like hedge-fund manager James Chanos warn, Beijing is now on a “treadmill to hell.” Bloomberg China economist Tom Orlik estimates investment as a share of China’s GDP has reached almost 50 percent, way higher than Japan’s 1990 peak of 32 percent in 1990.

The ratio of real estate investment to GDP, meanwhile, is in line with the highest levels seen in Japan.

It’s easy to understand why China would want more and more citizens to buy stocks. If a critical mass of Chinese feel paper-rich, they’re less likely to protest. They also may save less, spend more and help accelerate Xi’s rebalancing. But as Chinese shares soar, financial risks do, too. I can think of one word to describe that strategy: irrational.

*The author is a Bloomberg View columnist based in Tokyo and writes on economics, markets and politics throughout the Asia-Pacific region.

by William Pesek