Tuesday, July 7, 2015

The New Normal Equity Bubble and Policy Spirits

Ever since the Chinese economy entered a “new normal” of lower real economic growth, the Chinese stock market has appreciated rapidly. Considering the speed, value, and valuation of the equities in question, this episode can clearly be defined as a bubble. Most commentators have tried to explain this phenomenon as either the result of a declining real estate market diverting funds, the real economy decreasing needs for lending, rampant speculation, or a combination of all four factors. Although this could be considered another case of animal spirits by irrational participants in the market, a more accurate diagnosis would be to understand these events as reactions to official policy, i.e. policy spirits, not animal spirits.

The first culprits are wealth management products. They are a financial product that allowed banks to offer higher interest rate alternatives to customers while facilitating loans to higher risk clients. Savers got higher returns, borrowers got more capital, and banks got more fees, but with no risk for the banks, or so they thought.

On January 31, 2014, the Credit Equals Gold No. 1 wealth management product was due to mature. The wealth product had invested in a coal miner and was issued by the Industrial and Commercial Bank of China. The coal miner went bankrupt, so the planned interest and principle payment could not be honored. Before that point, no wealth management product had been allowed to default on principle. This policy is known as “gāngxìng duìfùi” in Chinese, or “rigid redemption” in English. Days before the wealth management was due to default, a mysterious third-party stepped in to cover the losses and recoup investor’s three billion yuan investment.[1]

In April 2014, the China Banking Regulatory Commission issued Document #2014/99, titled “Guidelines on Regulating Risks of Trust Companies”. The most important section was:
[Translation: "The shareholders of trust companies should include in their trust company charters a promise or agreement that when the trust company experiences liquidity risks, shareholders should provide support. If capital is eroded because of operating losses, the amount should be fully deducted from net capital, the scope of business should be reduced, or shareholders should promptly replenish capital."]
Now that stakeholder equity was at stake, trust companies had less incentive to offer wealth management products. Although wealth management products are still being issued, the number of available wealth products is decreasing. According to the Economic Observer, in 2015 Q1, banks issued 17,289 wealth management products, but 20,059 wealth management products came do, so the net amount of outstanding wealth management products decreased, at least in product offering terms. These funds had to seek yield in other investment classes.

In contrast with rigid redemption on financial products issued by trust companies, official policy towards bank closers has moved closer to market mechanisms of risk, profit, and loss. Since commercial banking was re-established in Mainland China since the 1980s, no bank has ever been allowed to fail. The largest banks in China are all state-owned, so there was an additional guarantee for those banks’ liabilities. In May 2015, the State Council established deposit insurance for all deposits with balances of ¥500,000 and under, our third culprit. It is not uncommon for a Chinese person in an area with low access to big state-owned banks to have more than ¥500,000 in a bank account. Now that official policy is to allow these banks to fail, depositors with more than ¥500,000 must find other investments. If originally a person had one million yuan in a small rural bank, the full amount was risk-free. Now, only half of it is risk free, the other half could be lost entirely, so any other asset class becomes attractive. This is one of the reasons we could be seeing such an increase in person-to-person lending, with much of it ending up in the stock market.

The third policy change that has caused animal spirits in the stock market has been the People’s Bank of China’s policy of reducing interest rates and reserve requirements. In Chinese, this policy is known as “shuāng jiàng”, or “doubling down” in English. Over the last six months, the People’s Bank of China has decreased interest rates and reserve requirements three times, each. At the beginning of the year, the reserve requirement ratio stood at 20.0%, but as of the end of June was at 18.0%. The targeted lending rate decreased from 5.60% at the start of the year to 4.85% at the end of June. This encourages banks to lend more of the deposits they have. At the same time, depositors are encouraged to seek out yield in other investments, such as the stock market.

Hopefully, when this artificial credit boom comes to an end, the central bank will be seen as the culprit, not the savior.