As China’s government attempts to prop up the nation’s stock market, pretty much every single investment firm has something to say about it. One firm compared the situation to what happened in Japan 50 years ago, and now another is offering lessons from what happened in the U.S. in 1987.
1987 may mean good news for China
The comparison with Japan suggested that things could much get worse before they get better in China. However, Deutsche Bank micro strategist Alan Ruskin suggests that the overall economic impact of the tumbling Chinese stock market may not be as bad as some are expecting.
His main observation is that the rally before the decline was “relatively short-lived,” which he thinks suggests that the “real economy implications from the pop” won’t be as bad as they were in 1987 in the U.S. The 1987 incident is often referred to as “the October crash.”
China’s similarities with 1987
Ruskin notes that at first glance, the run-up in China’s stock market this year looks very similar to the one in the U.S. in October 1987, especially looking a year before the 1987 crash. For one thing, the 1987 crash undid significant gains that came in the 10 months immediately preceding it. (All graphs/ charts in this article are courtesy Deutsche Bank.)
However, when looking more closely, he points out that China's run-up lasted for a much shorter period of time than the one before the October crash. Also China's run-up was much larger than the 1987 crash of the Dow in the U.S.
Ruskin thinks that the key difference is the amount of time over which the surge in share prices took place. He doesn't believe China's run-up lasted long enough "for a feedback loop to develop from higher asset prices driving a stronger real economy driving the asset bubble ever higher." He notes that the negative impacts on a real economy when a more short-lived bubble pops are typically not as "acute" as they are when a bubble has had more time to build up."
Alan Greenspan and the "plunge protection team"
China formed a group to buy up shares of companies in an attempt to prop up stock prices, and the country isn't the first to try something like this. Ruskin notes that around the 1987 time frame, the U.S. had a "mythical 'plunge protection team,'" which he said was essentially made up just of then-Fed Chair Alan Greenspan. Supposedly, the October crash caused the U.S. to create this team of top U.S. officials.
Today China's central bank funded the Securities Finance Corp. to support small caps—a strategy that hasn't always been effective. However, in China's case, Ruskin thinks it could work because Chinese regulators have fewer constraints when it comes to government intervention in cases like this.
Other good things for China
Another thing China has going for it is that the activity hasn't been mirrored in the majority of the world's other stock markets. The October crash in the U.S. was much more linked to other stock markets through the world, especially through lending across borders. China's main links to other markets are through commodities and interest rates.
Ruskin doesn't think there is much of a concern that China's issues will be contagious to the rest of the world's economies—unless there's a Grexit to compound the problem and further shock investors' appetite for risk.
The bad for China
Of course it's not all bright and sunshiny for China. For example, the Deutsche Bank analyst noted that there's a lack of transparency. He said this is a mixed bag because some good stocks and assets are "being sold to hedge illiquid asset exposure, but in the process, investor confidence is destroyed even though some stocks find good value creation.
Further, the analyst pointed out that China is capable of supporting stock prices for a short while. He added though that the artificial support should just be a "smoothing facility to encourage fair price discovery" rather than a long term solution because there are always problems artificially supporting prices. The analyst wrote:
"The U.S. substituted a late 1990s equity bubble with a housing bubble which did not end well. China’s experiment in substituting housing froth with equity froth, is plainly not succeeding. This all falls under the title: ‘troubles with policy traction’ that adds to China’s growth risks."
Naturally there will likely be some collateral damage to China's efforts, particularly the creation of credit being led by bank lending, most of which is backed by property. He said this could result in other asset classes being contaminated by the current equity crisis.
Chinese currency at risk
Perhaps the biggest risk associated with what China is doing has to do with currency. The central bank is battling on more than one front, with currency, interest rates, equity support, and the real economy all in flux.
The result is volatility in many areas, so it makes sense that regulators want to try to keep the RMB stable. Unfortunately though, China's monetary easing policies stand a good chance of weakening the nation's currency.
Overall, China's central bank has a delicate balancing act to deal with, and it won't be easy with so many difficult factors in play.
