China's stock market is screwing up its master plan

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angry chinese china woman

Reuters

As long as mainland China's largest stock market, The Shanghai Composite Index, continues to tumble, the country's plan to liberalize and reform its economy is screwed.

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"The Chinese government should have no appetite for either equity market bubbles or an equity market crash," Societe Generale analyst Wei Yao wrote in a recent note. "The equity market is deemed the best venue for financing for restructuring moribund state-owned enterprises.

"The ideal situation would be several years of a steady bull market to cover the restructuring phase. Conversely, the worst case scenario would be a stock market crash before restructuring has even begun. After China's stock market crashed in mid-2007, there was little sign of life for seven years afterwards. This time, China cannot wait that long for debt restructuring."

So it's either do or die.

For over a year President Xi Jingping has told his people that they need to expect slower growth as the government restructures a financial system bloated with debt and inefficiency.

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That, according to Communist Party leaders, is the best way to move China's economy from one based on foreign investment and government intervention, to one based on domestic consumption.

A rising stock market was integral to this plan to modernize the economy. It was supposed to provide the cash for debt-laden corporates as they restructured.

The shanghai composite index

Yahoo Finance, Business Insider

The Shanghai Composite Index year to date

But since June 12th the Shanghai Composite has not complied, falling almost 30% after an astounding year-long 150% surge. This, combined with a slowing economy, has spurred the government to action. Beijing cut rates for the 4th time since November, promised to go after manipulators in the market, suspended IPOs to create demand, and more.

On Saturday 21 brokerages pledged $19 billion to try to stop the slide, but as one investor told Bloomberg, that kind of money "won't last for an hour in this market."

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Much has been made of the sheer volume of individual investors in the market. Images of farmers day trading in remote villages, and reports of violence and suicide after levered investors realize losses seem bad enough to cause concern - but these are short term consequences.

At least, they are when you compare them to the consequences of China's plan for reform going off the rails.

"If, in response to the market volatility, the government had chosen to set back financial market liberalization, the trust of investors would be hard to rebuild and equity financing, one of the critical elements of China's debt restructuring plan, would stall," wrote Societe Generale.

If the stock market crashes, though, and it shaves 0.5% to 1% off GDP as Societe Generale estimates it could, then the government have no choice but to stall the machine.

Chinese President Xi Jinping

Ng Han Guan/AP

Chinese President Xi Jinping walks near a guard of honor at a welcome ceremony for Myanmar President Thein Sein in Beijing, China.

The government knows it's in a confusing mess, and in the messages it sends through state media outlets, it vacillates between being steadfast in its commitment to allow the market to correct itself and reassuring its people that if push comes to shove, it will step in.

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Here's an example from state-digest, The People's Daily:

"Some investors have insisted that the government is the one who can least tolerate a market stumble, and therefore it will definitely take action before the market gets even worse. Such expectations are one of the reasons the market often goes out of control - its own self-adjustment capability has become sluggish," said the editorial written on Saturday.

"We believe the government's management of the stock market should be based on market measures that are consistent with international practices. The government will not be able to babysit the market forever."

From the sounds of that, it seems China is ready to face the reality of the market let the pain set in.

Except that one paragraph later there's this: "Of course, if the market shows signs of getting out of control, the government will have to resolutely step in," the editorial went on to say.

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That's the contradiction, and Chinese leaders know it. If the government steps in, its stock market solution will have become part of the problem. Possibly a bigger problem than they'd imagined.

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