Pettis on the China stock crash

Courtesy of FTAlphaville comes Michael Pettis on the China stock crash:

It’s not just that markets are about volatility. It is that volatility can never be eliminated. Volatility in one variable can be suppressed, but only by increasing volatility in another variable or by suppressing it temporarily in exchange for a more disruptive adjustment at some point in the future. When it comes to monetary volatility, for example, whether it is exchange rate volatility or interest rate and money supply volatility, central banks can famously choose to control the former in exchange for greater volatility in the latter, or to control the latter in exchange for greater volatility in the former.

Regulators can never choose how much volatility they will permit, in other words. At best, they might choose the form of volatility they least prefer, and try to control it, but this is almost always a political choice and not an economic one. It is about deciding which economic group will bear the cost of volatility.

But one way or another there will be an enormous amount of volatility within the Chinese economy, not just because it is a relatively poor developing country, which have always been more volatile economically than advanced countries, but also because it is so highly dependent on investment to generate growth. Hyman Minsky argued that economies driven by investment are extremely volatile and overly susceptible to changes in sentiment, and he is almost certainly right.

…The Chinese stock market panic is unlikely to trigger a financial crisis in China, but not, as many argue, because of its relatively small size and narrowly dispersed ownership. What matters is that although nationally there are significant mismatches between assets and liabilities among individual institutions and within particular sectors of the financial services industry, and these mismatches are highly pro-cyclical, China is protected from crisis by its relatively closed capital account, its high level of reserves, and most importantly of all, the fact that much of the mismatch between assets and liabilities are resolved on a system-wide basis through Beijing’s implicit or explicit guarantee of most components of the country’s financial system.

China is protected from the risk of financial crisis, in other words, mainly by Beijing’s credibility, which remains very high.Without this credibility, more than three decades of rapid growth accommodated by a financial system designed for credit expansion has left the country with what would otherwise be an extraordinarily vulnerable balance sheet.

Inevitably as the country unwinds the balance sheet mismatches, debt has grown more quickly than expected and the economy more slowly in a mutually reinforcing process. This will continue as Beijing rebalances the economy, temporarily increasing the country’s underlying vulnerability until it is able to rein in credit growth and resolve the uncertainty about how the growing gap between debt servicing costs and debt servicing capacity is assigned. As long as the credibility of the implicit Beijing guarantee is maintained, however, I think that while China suffers from excess debt, it is unlikely to suffer from balance sheet instability.

There are two important implications. First, policymakers must ensure that protecting Beijing’s credibility is a priority. Second, investors must ensure that they evaluate changes in credibility accurately.

…It is too early to say, but the extent and ferocity of the market break and the panicked response of the regulators may result in even further convergence. If the rally is restored I have little doubt that the regulators will take steps to try to limit volatility. Margin, for example, will never be allowed to reach the extent that it had (and this has implications for credit growth, by the way), and a little sand might be thrown into the machinery, perhaps by raising transaction taxes or forcing wider bid-offer spreads. But we shouldn’t overestimate their impacts. If Beijing is able credibly to revive the rally – a big “if” – we will want to watch closely whether once again most investors are cynically riding what they believe to be a bubble.

…So where do things stand now? It is pretty clear to me that Chinese investors recognize that they have collectively decided that the correction has ended and that prices are going to rise. In a speculative market this is all it takes for prices to rise.

But while this recognition seems quite solid, in fact there are a number of factors that can quickly undermine it, and what matters is not new information the suggests prices must fall but rather just new information that undermines confidence in the strength of the consensus. This may not seem as important a distinction but in fact it is. It doesn’t necessarily take bad news to cause prices to fall again. News that undermines our confidence that there is widespread agreement about our collective consensus is enough to do that.

What worries me most is that many of the measures employed by the regulators to halt the panic are unorthodox enough, to put it mildly, that they can introduce all kinds of new convexities and implied options that we don’t fully understand. As we begin to recognize and understand them, however, these might be enough to undermine confidence in our widespread agreement about having reached a consensus…

In this market, you buy because you believe that everyone has agreed on the collective interpretation of government signaling. Anything that undermines the confidence you have in the collective interpretation must undermine your decision to buy, and in fact because everyone is watching everyone else, at some point, this can become a collective decision to sell.