The parallel banking system that funneled billions into stocks may be about to unravel.
Why can’t China’s government stop the plunge in share prices on its stock exchanges? This week I spoke to
Viral Acharya, a colleague at New York University’s Stern School of Business, about the causes of China’s share price bubble and the consequences we’re seeing today. He’s part of a research team studying how the growth of shadow banking — the creation of bank-like deposits outside the regulated part of China’s banking system — turned a simple correction into a crisis. And he says the worst isn’t over yet.
The reason has to do with the involvement of China’s shadow banking industry in the recent run-up of share prices. Because rates in China’s regular banking industry are heavily regulated, banks have been offering high-yield alternatives to regular deposits. By promising high fixed returns, they attracted billions of dollars from Chinese savers, and much of this money went into the stock markets. But in the process, the banks created a huge amount of leverage that has made the post-bubble markets uncontrollable.
Below are some excerpts from our conversation. You can also read more about the research
here.
Foreign Policy: How do we know that there was a bubble in China’s stock markets?
Viral Acharya: Especially over the last year, the stock market appreciation was out of sync with the fundamentals of the economy. The collapse of the recent few months has pretty much wiped out the gains since January, but if you take the 12 months August to August, you still have about 35 percent to go. You basically had a 100 percent return in 12 months. Something phenomenal would have to happen in order to see that price appreciation. If there were some underlying economic boom, then it would be easier to rationalize what happened. But all the signs have been at best tepid.
FP: So what did cause prices to rise so quickly?
VA: It can be attributed to leverage, including margin-based lending that got put into the stock market.
FP: The margin-based lending has been a big story, but your research suggests that another source of leverage is the shadow banking system. How did that happen?
VA: Shadow banking in China has grown tremendously in dollar terms, to more than $2 trillion. It is made up of attempts by regulated banks to issue deposit-like products — but not actual deposits — and offer higher interest rates to investors, given that deposit rates are regulated and suppressed. Banks float wealth management products as trusts, their own special purpose vehicles, marketing them as relatively safe paper and offering higher rates than regulated deposit rates. Of course, the higher rates have to be generated in some way, so they often find their way into riskier projects. The bulk of this was going into real estate and infrastructure built by municipalities.
FP: How did that money eventually make it into the stock market?
VA: The shadow banking paper that banks were floating could no longer go into real estate and infrastructure projects, because those were slowing down. They basically put the money into the stock market. They did it in a very leveraged fashion, similar to what happened in the United States with mortgages up to 2007. From one underlying pool of risk, you created a safer and a riskier tranche. And they’ve done something very similar in China. They make an equity investment, but they convert it into a structured product. The idea is that up to a certain return of the underlying stock, that becomes a fixed-return product, and anything above that is a variable-return product.
FP: Who was buying the two products generated from the investment in stocks?
VA: The subordinated piece — the one that was going to absorb the variable equity return — was bought typically by hedge funds, broker-dealers, and riskier-profile institutions. And those who bought the safer products were those who would usually go into the deposit market but were lured by the higher rates.
FP: Those promises of high returns presented some huge liabilities for banks, right?
VA: The trusts are basically investing in equities not with a lot of equity capital of their own. You’re creating a banking-like balance sheet, but investing in equities. That’s going to create tremendous leverage.
FP: So the depositors in the shadow banking system lent banks billions of dollars to invest in stocks, expecting a high fixed return. What happened when the return on stocks wasn’t high enough to pay what was promised?
VA: The leveraged stock investments are only now coming under stress. But in the recent past, they did come under stress when the housing and infrastructure slowdown caused revenues from the sale of municipal land to dry up, creating risks for shadow banking vehicles that funded municipal debt. In fact, since 2013 there’s been a series of episodes where shadow banking vehicles have come under stress. It has usually led to problems in the interbank market, as banks sponsoring the stressed shadow banking vehicles start hoarding liquidity. The People’s Bank of China has tried to smooth out these episodes, barring a few exceptions, by injecting more liquidity.
FP: Does that mean that investors could assume the trusts or so-called wealth management products had an implicit guarantee from the government?
VA: Yes, and to a degree they were right. The downside risk was not fully priced, because they expected some form of implicit or explicit government guarantees — and all of this has been seen in the last few months.
FP: A guarantee like that, explicit or otherwise, would just have added fuel to the fire.
VA: If equity holders are primarily betting on the upside and not taking into account the downside, because they expect some support from the government, then they’ll be willing to pay a lot for these stocks. This can continue for a while, but at some point these leveraged investors will want to cash out. They’ll know that you can’t have 100 percent returns year after year. Also, regulators in China are rightly trying to clamp down on shadow banking growth, but the damage has been done and there will be consequences of causing shadow banking to unwind.
FP: Is that what we’re seeing now, just buy-and-hold investors cashing out and taking profits? The government in Beijing is blaming short sellers — especially among foreign investors — for the crash.
VA: Usually when you see market corrections of this type, the historical experience is that it’s not short sellers. It’s the holders of the stock who are usually selling. Had there been a strong short-selling possibility — had the markets been as liquid as in the United States — then this wouldn’t have happened in the first place; the correction would have happened much more quickly.
FP: Given how big the bubble did become, how much can this crash in the markets affect the real economy?
VA: The main reason you would be concerned about some rapid stock market correction is because there is some leverage in the system. Even though the NASDAQ crash was dramatic in 2000, it had nothing like the effects of the housing crash in 2007 and 2008. Even though there was some leverage, the amount there was nothing like the amount of leverage that went into the housing market.
FP: It sounds like the deleveraging will be more painful than the destruction of wealth on paper.
VA: I don’t think the stock market correction is such a big deal. The bigger concern is that part of it is collateral for these senior, fixed-rate tranches. At some point it might be serious enough, as in the United States, that the senior tranches might start worrying about whether they’re going to get their recoveries or not. This could trigger some runs on the shadow banking vehicles. If banks don’t cover them as guarantors, they could risk a reputational run on the rest of their assets. The banks may have to cough up the capital.
FP: That would really strike a blow at China’s already weakened banks, perhaps enough to cause a new crisis. Will Beijing be able to set some kind of floor for the markets to stave off this possibility?
VA: The monetary easing that has happened over the past year, the continued growth of shadow banking, the switch in shadow banking from a market that seemed to have plateaued — namely housing — into the stock market, together have led to leveraged investments in the stock markets. That’s why it’s very hard for them to make any floor.
FP: All of this suggests a pretty gloomy outlook for China.
VA: The news from the macroeconomy has been even more mixed, maybe more negative, in the last three or four months. And I’m sure that the haphazard policy response has really scared foreign investors. But as the episode unfolds, you realize some things about the use of debt-fueled stimulus for the economy, of the type that China has pursued since 2008, when underlying growth is weakening. It produces short-term gains by making investment and output seem stable but carries the long-term risk of a protracted slowdown. Japan in the 1990s was the same phenomenon, and mortgage-based stimulus of the American economy in the decade before the global financial crisis was much the same, too. It seems each country needs its own crisis to learn the hard lesson. It must be that the underlying political imperative to generate short-term growth at all costs is too strong, and political time horizons are far too short.
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