The two 7 percent declines in Chinese stocks last week, coupled with a dropping renminbi, are signalling danger. In turn, the S&P 500 dropped 5.7% for the week, giving rise to what NYU's Volatility Lab characterizes as systemic events. These market movements are warning us about the risks associated with financial instability, risks that have psychological pitfalls at their root.
My new book Behavioral Risk Management devotes a lot of attention to explaining the psychological drivers of financial instability, viewed through the lens of the financial instability hypothesis developed by the late economist Hyman Minsky.
The financial instability hypothesis involves a series of components, the first of which is excessive leverage. As I wrote in a previous Forbes blog post, China’s leverage is very high. Keith Bradsher, writing for The New York Times this past week, makes this point several times.
First Bradsher’s article tells us that in 2008 Chinese authorities responded to the global financial crisis by developing a $585 billion stimulus package, and channeling this money into transportation infrastructure. Viewed through the lens of the financial instability hypothesis, this strategy made a lot of sense.
Second, Bradsher’s article tells us that during recent months when the Chinese stock market weakened, Chinese authorities reduced interest rates in an effort to stimulate growth. To do so, the country’s central bank injected more funds into the financial system, in order that banks be able to continue lending, thereby increasing leverage even more.
Third, Bradsher’s article tells us that the Chinese economy is dotted with many struggling companies that should be shut down on economic grounds. Notably, debt is keeping these firms alive, and this fact raises a big red flag when viewed through the financial instability hypothesis. In the short-term, if Chinese authorities engage in deleveraging and shut down these firms, they risk eroding the confidence necessary for growth. Curtailing growth by curtailing debt creation would lead to mass layoffs, social unrest, embarrassment for Chinese leaders, and bad news for the global economy.
China has a self-control dilemma because it faces a choice between accepting moderate pain now or much greater pain in the future. Much of Chinese commercial debt qualifies, in the language of the financial instability hypothesis, as “speculative finance” or “Ponzi finance.” These two forms of finance rely on capital appreciation, rather than cash flows, to fully service the debt. The greater is the proportion of speculative and Ponzi finance in the overall debt mix, the harder will be the fall when the fall comes. And come, it will. The choice: take some pain now or a lot more pain down the line.
Much of what is happening in China today is the result of Chinese authorities attempting to artificially induce and maintain euphoria. Part of their measures has included not just limits on short sales, but limits on selling. These restrictive measures were introduced last summer as a colossal Chinese stock bubble began to burst, and were temporary. As the restrictions started to lift this week, the associated selling resulted in deep declines in the value of Chinese equities, halted only by circuit breakers and a general suspension of trading. The selling suspensions have now been extended, thereby kicking the can down the road.
The fundamentals for Chinese stocks are not good, and nothing will change that. Chinese authorities can delay the reckoning but not prevent it. The dropping renminbi will not change that even though, all else being the same, a lower renminbi will stimulate demand for Chinese exports. Such demand could conceivable increase Chinese production, profitability, and debt servicing.
However, not all is the same. China’s Asian neighbors appear poised to let the values of their currencies drop as well, in order to stay competitive with China. If they do not devalue, Chinese products will be more attractively priced than theirs.
The artificially induced euphoria has resulted in the buildup of a lot of systemic risk. Eventually that systemic risk will erupt. However, what we know from the global financial crisis is that during the euphoric stage, markets miss the buildup; and the eruptions surprise most.
We are past the euphoric stage, and there are clouds looming on the horizon. Very importantly, global trading activity is on the decline. As China and its neighbors devalue their currencies, they will buy less from their trading partners. In turn, this will weaken their partners’ economies and render the state of their financial sectors, especially debt financing, more fragile. The risk of debt default will rise.
Excessive debt arises from poor risk management, sets the stage for financial instability, and increases the potential for full blown financial crisis. I wrote about this issue in a previous blog post. The markets are sensing that dysfunctional risk management in China is going global, as we move closer to the point where the instability erupts into another financial crisis.
