China’s bonfire of the liquidities has claimed its first victim: equities. Stocks in Shanghai and Shenzhen tumbled more than five percent on June 24 after the central bank published a letter suggesting it’s in no rush to help overstretched lenders continue in their bad habits. This tough new approach could mean a little more chaos will be injected into China’s financial system. For the economy overall, it’s both positive and helpful.
The Shanghai exchange’s worst day in nearly four years is a signal rather than a problem. Chinese companies don’t really rely on the equity markets as a source of new capital: not one new share issue has taken place in Shanghai in 2013. The negative “wealth effect” of falling stocks on consumption is unlikely to be significant either, since China’s 1.4 billion people have only 136 million stock-trading accounts; only a third of them have traded in the past year.
But the sell-off is still significant. The central bank says it wants finance to benefit the real economy, yet recently it’s the financial economy that has been benefiting more. Total financing grew almost six times as fast as nominal GDP in the first quarter, year on year. Some of that probably kept profligate borrowers alive, while some will have supported speculation in housing, office blocks and stocks.
Banks’ lending books may be next to feel the flames. Short-term funding rates remain elevated, making it more expensive for overextended lenders to rely on their peers’ largesse to fund regular business. Over the coming months, some may have little option but to pull in lending, or start to write down debts that will never be paid back. A painful increase in bankruptcies and forced asset sales could result.
That kind of financial pain is what China needs. Banks have run amok, believing that the regulators wouldn’t let them come to harm. They’re still partly right: it’s unlikely the authorities would let a lender fail outright. But the new tone of non-intervention – and the fact that investors are taking it seriously – is encouraging. If the result is better use of funds, it should eventually be good for equity investors, and everyone else too.