China's Engineered Drop



China's Shanghai Composite Index tumbled 8.84 percent Feb. 27, its largest fall in a decade. Its sister index, the Shenzhen Composite Index, fell 8.54 percent. The size of the drop in China is not significant in and of itself. On a number of occasions during the past year, the Shanghai Stock Exchange has experienced 5 percent plus daily reductions, and it has already boomed and busted once this decade.

But that hardly means the development is insignificant. The fall is important both for how it happened and what it triggered.

How it Happened

This was an engineered drop.

The Chinese government has become increasingly concerned about levels of investment in its economy or, more accurately, the sheer amount of money that is chasing projects. State firms with limitless access to subsidized capital from state banks have used that access to launch thousands of nonprofitable firms. This glut in "investment" money drives up the cost of commodities and adds industrial capacity without actually producing anything of much use, making life more difficult for the average Chinese and unduly harming relations with foreign powers that face a glut of otherwise noncompetitive Chinese goods.

This penchant for overinvestment has now spread to the stock market in two ways. First, the same politically connected government officials who started dud companies are taking out loans to buy shares, or are using shares they already hold as collateral for new loans. Second, ordinary Chinese citizens have started borrowing -- sometimes against their homes -- in order to play the market. In January, the number of total traders on the Chinese exchanges grew by 1.38 million, an increase of 134 percent from a month earlier, while stock turnover was up 700 percent from a year earlier.

The net result is an absurd stock surge with no basis in fundamentals. At present, some Chinese banks now have price-to-earnings ratios higher than financial behemoths such as Deutsche Bank and Chase, despite deplorable management and a history of highly questionable lending policies.

For the past few months, the government has been working to drive down this speculative investing. On Feb. 26, China's State Council launched a new "special task force" that accurately could be referred to as the "get-those-idiots-to-stop-borrowing-to-gamble-on-the-stock-exchanges" team. Its express goal is to get the Chinese domestic security brokers to lay off such speculative decision-making, while also putting a crimp in the source of the subsidized capital.

Day one started by the script, and Beijing is likely quite pleased with the way things are going (or at least it was until its actions unintentionally triggered a global meltdown). Also, since the Shanghai exchange is actually still up 3 percent for the past week despite suffering its largest drop in a decade, the State Council probably hopes for more drops in the days ahead.

What it Triggered

But the rest of the world took a different lesson. Why the Chinese stock crash occurred was unimportant to the outside world, only that it did -- and that it affected everyone else.

For the first time, China has become the trendsetter in the global stock community. Normally, the U.S. exchanges -- especially the S&P 500 index and the Dow Jones Industrial Average -- set the tone for global trading patterns. Not on Feb. 27. This time, China led Asia to a wretched day. The wider the contagion spread, the more margin calls were forced to be called in. (If an account's value falls below a minimum required level, the broker will issue a margin call for the account holder to either deposit more cash or sell securities to fix the problem.)

As the drops snowballed, Europe filed in dutifully behind, mixing the China malaise with its own nervousness about overextended markets in Central Europe and the former Soviet Union. By the time markets opened in the United States -- where investors already were fretting about the subprime mortgage markets -- the only question remaining was how far U.S. markets would descend. In the end, the Dow dropped by the most since the fall triggered by the 9/11 attacks.

So why has this not happened before now? As China's market capitalization has increased, its links to the global system have increased apace. These links have developed very quickly, and with few controls. The Shanghai exchange, for example, more than tripled in total value in 2006 to more than $900 billion -- and much of the rapid-fire initial public offerings (IPOs) of Chinese banks on the Hong Kong and other international exchanges are not included in that little factoid. Indeed, China's mainland exchanges are only the tip of the iceberg -- and they certainly do not include foreign firms that are heavily invested in the mainland.

Two years ago, China's market capitalization was too small for its problems to impact the global system. Now, between ridiculous foreign subscriptions to IPOs, irresponsible corporate policies and irrational valuations all around, that capitalization is to a level -- around $1.3 trillion -- where its integration with the global system via funds and margins makes China a sizable chunk of the international financial landscape. The insulation that once protected international exchanges from Chinese policies is gone, which makes the international system more vulnerable to Chinese crashes.

Feb. 28 and Beyond

Follow-on crashes can come from one of three places.

First, the Chinese believe their exchanges are massively overvalued (hence the engineered crash). They will do this again, and are not (yet) particularly concerned with the international consequences. China planned to dampen its own stock market, not the world's markets. Along with the rest of the world, Beijing did not expect the contagion effect to be so extreme. Yet, for now at least, China's own exchanges are its primary concern, and it will act according to that belief.

Second, everyone else now is going to chew on the fact that Beijing did this intentionally. They will either agree with the Chinese that the exchanges are overvalued and that additional measures are needed, or they will be terrified that Beijing did this intentionally and not care about the reasons. Whether what is sold is a domestic Chinese firm or a foreign firm invested in China does not matter much. Neither does it matter if the stock is on an exchange in China or abroad. Either way, the reaction will be the same: Sell.

Third, trading in 800 of the 1,400 stocks on the Shanghai exchange was suspended during the sudden drops Feb. 27; they have a lot farther to fall, even without any engineered drops caused by panicky selling.

Considering the flaws on which the Chinese system is based, this certainly will not be the last engineered drop. In theory, the move will make foreign investors far more cautious before diving into the Chinese system, but as longtime Stratfor readers know, we have been wrong on the timing of that particular development before.