The Blame is on China’s “Shanghai Surprise”, But....

``Markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected.” -- George Soros

MEDIA has been plastered with reports that China’s “Shanghai Surprise” was the culprit to last week’s highly volatile activities worldwide. Nonetheless, the public including many analysts openly embraced such supposition.

As a disciple of the market, we try to keep in mind the premises of Frederic Bastiat’s theory; “That which is Seen and that which is UNSEEN” or the parable of the Broken Window. The theory essentially deals with OPPORTUNITY COSTS.

What is SEEN today is that CHINA’s crash virtually CAUSED the maelstrom in the global financial markets last week.

While it may be true that the initial tremors in the global markets have been staged at China, the predicated causality is very much in doubt. In other words, I do not share what I perceive as a logical fallacy POST HOC ERGO PROPTER HOC “after this, therefore because of this” as espoused by the mainstream.

Figure 1: Bloomberg: Shanghai Composite: Not The First Time!

The market usually responds to a shock violently. But, in the case of China, this is clearly not the first time! Morever, the last shock happened in less than a month’s period!

In Figure 1, courtesy of Bloomberg, China’s bourses have come under siege from its authorities trying to rein in the “bubble-like” phenomenon in its equities market.

In late January of this year, according to a Forbes report, ``Cheng Siwei, vice-chairman of the National People's Congress, warned investors not to engage in speculative activity in the stockmarket because of the risk of a bubble developing and bursting, causing heavy losses, the Financial News reported.”

The warning allegedly contributed to a harrowing one day 6.5% decline as exhibited by the red arrow on both the Shanghai and Shenzhen bourses. Yet, the world has basically ignored such happenstance.

Could this suggest that since the world discounted the earlier drop, that the bigger magnitude (9.2% on Tuesday) had more of an impact to trigger a domino effect? I doubt so.

Second, one must be reminded that China’s financial markets are severely constrained by choking government regulations, where both domestic and foreign investors have limited options. Edmund Harriss of Guinness Atkinson describes best the conditions from Ground Zero (emphasis mine),

``The Chinese stock markets are in reality very thin in terms of market participants. In spite of the huge numbers of brokerage accounts a small number of funds, companies and high net worth individuals dominate the market. And they invest on the basis of Technical Analysis (i.e. price patterns) and News Flow, not on Valuations.

``The markets are also ring fenced by China’s closed capital account that means there is no general freedom to move money in and out of the Yuan or in and out of the country. Foreign investors are allowed into the domestic market but on highly restrictive terms and local investors are not allowed to go outside except on highly restrictive terms.

``So local investors don’t really have a choice. Or they do, but not a very attractive one. They can invest their money in bank deposits which will pay 2.52% for a one year deposit; or they can buy a 2.5% guaranteed return product from an insurance company; or they might invest in government bonds that currently yield under 2.65% for the ten-year, if they can get them. No wonder that when they see a hot thing they are on to it.

``But this means that Chinese stock markets do not adequately reflect local economic conditions, in our opinion and therefore should not be used to predict global ones. High volatility and high valuations are part and parcel of inadequately functioning stock markets.”

In an interview at Bloomberg, the illustrious veteran Mark Mobius of the Templeton fund basically shares the same view that China’s market is overvalued whose present activities shows disconnect from economic realities. Mr. Mobius thinks that China’s bourses will continue to suffer from selling pressures over the interim.

Figure 2: LA Times: Tail Wags the Dog?

Third, it is important to note that for a domino effect to take place means having a significant correlation on certain variable/s. In this case the connecting factor should be accessibility of foreign money to China’s equity assets. Yet, Mr. Harriss mentions that investments from foreign investors are as limited. LA Times estimates that these accounts for less than 3% of its market value.

Theglobeandmail.com quotes Arthur Kroeber, director of Dragonomics Research in Beijing in estimating the size and depth of the Chinese market, ``Although the official market capitalization is $1.3-trillion, most of this amount is in shares that cannot legally be traded until 2008 or 2009 because of rules imposed when they were converted to A-shares...Only about $400-billion worth of shares can be legally traded now, and of this amount, only about $160-billion are held by retail or institutional investors.”

Globeandmail.com continues (emphasis mine), ``This means that 60 per cent of tradable shares are controlled by state corporations, government agencies, the police, the army, or large private investors with dubious legal status.”

This brings us to question on the foundations of the “China-driven contagion”; how SIGNIFICANT can it be for China’s $400 billion worth of tradeable shares or even less (remember 60% held by the ruling class) or $1.3 trillion of market cap [representing a measly 2.2% of the aggregate global market cap, see figure 2] to severely AFFECT a northward $70 trillion in world market cap?

The corollary is to suggest that Philippine market’s crash (market cap about US $80+ billion) CAUSED the carnage of the China’s bourse. How awkward can such reasoning be!

While I am seeing a sea of blood across the world’s bourses following Tuesday’s selloff, it is noteworthy to observe that Vietnam has been entirely unscathed and continues to race upwards with an amazing 5.95% advance over the week! In other words, because Vietnam’s stock market has a similar construct to that of China, i.e. restricted foreign investments, it has been less susceptible to global capital flow dynamics and relies on domestic developments as its main driver.

Remember in this age of digitalization, we are talking about global money flows at the click of a mouse. It is worth repeating that while China’s market cap is ONLY US$1.3 trillion, where about $200 billion is essentially exposed to the public or could be owned by foreign money! In contrast, our domestic market has been dictated by foreign money accounting for more than HALF of its turnover since the cycle reversed in 2003. This subjects us to the shared risks and benefits of a globalized market.

In addition, China’s loss of ten percent (10%) in nominal terms is equivalent to only US$ 130 billion, in contrast to the aggregate US market cap, which at an estimated US $27 trillion (NYSE, AMEX, Nasdaq et. al.), lost US $810 billion or 3% (rounded off) or about two-thirds of China’s market cap! So which do you think is suppose to have a larger impact on global markets?

Fourth, while it is said that the new rules imposed by the Chinese authorities aimed at curbing rampant speculation as being responsible for the carnage, this seemed to have a belated effect. According to Barry Ritholtz (emphasis mine),

``China's Shanghai and Shenzhen stock exchanges issued on Sunday the new rules of regulating their member securities companies in a bid to ward off risks in stock trading. The rules, which will come into effect on May 1, set limits to the varieties, methods and scales of stock trading that dealers are allowed to conduct, preventing them from engaging in high-risk business beyond their capacity.

``Note that these details were released on Sunday, and on Monday Chinese markets set new all-time record highs! Indeed, despite recent official discussions of new capital gains taxes, increased regulation and the government's desire to reduce speculation in China, their indices had advanced 13% in the prior six sessions -- all setting records.”

Where markets are supposed to react to new information supplied, a seemingly belated effect implies detached reality. In other words, China’s market fell NOT on the NEW rules but on some other underlying UNSEEN factors.

With the snowballing signs of mania, where people have now been borrowing against their homes to gamble or “dubo ji,” or the slot machine, as the New Times calls it, on the stock markets, the government perhaps or probably made use of their sizeable ownership of listed companies to douse on the brewing irrational exuberance by dumping their shares.

Why? Perhaps for political survival, Morgan Stanley’s Stephen Roach thinks that the present leadership views market intervention as part of measures to stabilize the situation, he writes (emphasis mine), ``In China, stability is everything. The Chinese leadership believes it cannot afford to lose control of either its real economy or its financial markets. Pure market-based systems can rely on interest rates, currencies, fiscal policies, and other macro stabilization instruments to contain the excesses. A blended Chinese economy does not have that option. The quasi-fixed currency regime compounds the macro control problem — making it difficult for China manage its currency in a tight range without fostering excess liquidity creation. That puts the onus on Chinese policymakers to opt for non-market control tactics. Just as China has moved to bring its central planners into the business of containing the excesses in the real economy through administrative measures, I suspect it now feels compelled to rely on a similar approach in order to deal with excesses in its financial system.”

In short, for investors, it is hard to earn on markets where the APPARATCHIKS DECIDES TO PLAY GOD!

Anyway, I don’t think much of the market actions in China would diffuse into its economy or translate to a consumer crisis, considering that only about 8% of the household assets as estimated by the Mr. Harrisss of Guinness Atkinson are exposed to equities (76% in bank deposits, 9% bonds, 7% insurance). You’d have to look elsewhere for a compelling case that could trigger a “domino effect”.

For all its worth, I believe that the global markets have simply used the “Shanghai Surprise” incident as merely a scapegoat for something much deeper, yet the public has warmly accepted such logical fallacies as “truths”.