Darrell Duffie: China’s Risky Effort to Prop Up Stocks

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An investor looks at an electronic board showing stock information at a brokerage house in Shanghai, China, on July 10, 2015. | Reuters/Aly Song

At least for one day, the Chinese government looked as if it might have the power to stop and even reverse the world-rattling plunge in China’s stock markets.

After a raft of new state interventions to prop up stock prices, from tough restrictions on selling shares to massive new loans for major brokerage firms, the Shanghai stock market shot up 6% on July 9.

Given the 30% free-fall that had occurred since early June, erasing $3 trillion in stock-market wealth in a matter of weeks, investors around the world undoubtedly felt huge relief. Maybe even gratitude.

But Darrell Duffie, professor at Stanford’s Graduate School of Business who closely follows China’s financial system, warns that the government’s determination to tame market swings could sow dangerous complacency and actually increase risk down the road.

“It sounds nice to have the government protecting you, but it has unintended consequences,” Duffie says. “If government actions actually do prevent the markets from declining very much, then people will say, ‘Oh, this is great. The market will never really go down all that much because the government is going to step in.’”

The problem with that kind of misplaced confidence, Duffie says, is that investors will be more likely to bid equities to unreasonable heights. “That means capital is being misallocated, and that many firms are getting funding even though they probably don’t have good business plans.”

Many people already suspect that Chinese government actions contributed to China’s market roller coaster over the past 12 months. Chinese stock indices surged nearly 200% between June 2014 and June 2015, fueled in large part by huge increases in “margin financing” — stocks purchased largely with borrowed money.

Although Duffie says the government did not explicitly promote that manic buying, senior officials made soothing and encouraging comments about stock values and moved very slowly to tamp down the rampant borrowing by stock investors.

When prices fell, investors had to put up more collateral and increasingly had to sell shares to cover their debt, which drove prices even lower. As valuations plunged at frightening rates early this month, the government announced more than a dozen actions to slow the new wave of selling.

Among other moves, the state assets regulator urged state-owned enterprises to buy up more of their own shares. Meanwhile, the China Securities Finance Corp., the state-owned agency that lends money for margin-buying, offered 260 billion yuan ($42 billion) in loans to major securities firms. The central bank vowed to keep money flowing as well. Regulators also cracked down on short-selling and prohibited shareholders who own more than 5% of a company from selling shares less than six months after buying them.

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The Shanghai Stock Exchange Composite saw a huge drop earlier this month but is picking up after state interventions.

On top of all those government actions, legions of Chinese corporations have suspended trading their shares to prevent them from sinking lower. Through much of early July, more than half of all listed shares weren’t trading at all.

“The most interesting part of all this has been the government’s reaction,” Duffie says. “They want control. It’s their legacy manner of managing the economy. It’s only been about a quarter of a century of relatively price-based economy, so they don’t have a very long experience in just taking their hand completely off the tiller. And now, when they’re being buffeted by a really big storm, they want to put their hand right back on the tiller so the boat doesn’t capsize.”

The motivation is understandable. American stock exchanges have short-term “circuit-breakers” to deal with spikes in volatility. During the financial crisis, the Federal Reserve dramatically expanded the money supply and ramped up special lending programs.

But Duffie cautions that China’s direct market interventions pose two big “reputational” risks for policymakers. If the interventions fail, they will further weaken public confidence in both the markets and the government’s effectiveness. Going forward, investors may also worry more about the political uncertainty that underlies the earnings outlooks of their companies.

If the government’s intervention succeeds, however, Duffie warns that it creates moral hazard — a belief by market participants that the government will rescue them from their own mistakes.

Duffie notes that China has an additional reason to be wary about a misplaced confidence in government protection. The nation is in the process of gradually opening its capital markets to cross-border capital flows. As those flows increase, both in and out of China, the government will have even less ability than it does now to stem fire sales of its financial markets. That could be a very unpleasant shock to Chinese investors.

Should Americans be concerned? Yes and no, says Duffie. On the one hand, American investors will suffer few direct losses because China still has tight restrictions on foreign ownership of Chinese equities.

On the other hand, however, the Chinese stock market is now a major component of the Chinese economy — which in turn is a primary engine of global growth. On that score, look no further than how U.S. stock markets gyrated in response to both the free-fall and rebound in Chinese equities.

Indeed, the Federal Reserve’s summary of its most recent policy meeting cites turbulence in China (along with Greece) as a potential cloud on the U.S. economic outlook. And that meeting took place before the Chinese stocks had truly begun their plunge.

“That just reflects the underlying macroeconomic conditions,” Duffie says. “China is very important, not just to the United States directly, but also indirectly as a support to the rest of the global economy….This is not a sideshow.”