Deutsche Bank: What China Can Learn From the 1987 ‘Plunge Protection Team’

Look out below!

Dewitt

Chinese stocks have been taking the plunge.

Photographer: Don Knight/The Herald Bulletin

After the Shanghai Stock Exchange Composite Index slid 5.9 percent, to 3,507.19, on Wednesday, it bounced back 5.8 percent, to 3,709.33, today. 

With the roller coaster ride continuing, Chinese officials have taken action.

Over the past two weeks, they’ve unveiled fresh measures almost every day in an effort to boost confidence and reverse a rout that saw the market lose $3.9 trillion in less than a month. The Shanghai Composite had traded as high as 5,178 just last month before its historic crash.

Obviously these huge moves have Wall Street buzzing, and Deutsche Bank’s Alan Ruskin has written a note sharing his thoughts on how a “plunge protection team” could both benefit and hurt the Chinese market. Ruskin draws similarities between the current crash in China and the one in 1987 that saw global stock markets plummet. The first chart he uses shows the startling similarities between the two, in both the runup and the crash:

Although if you look at Ruskin’s following chart, which normalizes the data, Shanghai’s runup is far more drastic:

The 1987 plunge protection team, as Ruskin puts it, was the group of senior U.S. officials created in the aftermath of the 1987 crash and often perceived to be helping to prop up the market. The pros for China of embarking on a similar course are rather apparent: It enables the country to smooth what could be volatile price declines. As noted above, China is already embarking on some extreme measures to strengthen equities.

But the potential drawbacks of all that extraordinary market support are more interesting. As Ruskin writes (boldface ours):

The flip side of any official equity intervention, and as important the recent suspension of trading in some shares, is the obvious lack of transparency. … China has the resources to support the equity market in the short-term, but there are inherent problems in artificially supporting prices. It undermines the markets [sic] confidence that a base has been reached, and in the long-term further distorts the allocation of capital. These are arguments why plunge protection should be no more than a smoothing facility to encourage fair price discovery.

At a time when China is trying to accomplish many, many things, there’s a risk that long-term plunge protection could prove ineffective, and thereby provide “‘proof’ that the [People’s Bank of China] is not omnipotent,” as Ruskin says. Here’s his conclusion:

[Alan] Greenspan’s rate cuts immediately after the 1987 crash did seem to stabilize the situation. He was a one man plunge stabilization team, and this was in retrospect the early stages of the “Greenspan put.” Even this “put” distortion was ultimately seen having huge costs. The PBOC is already much more stretched than the Fed ever was. They are struggling with “the holy trinity”—maintaining a currency peg for stability, interest rates and [reserve requirement ratio] directed at the real economy, equity support, and all this while attempting to liberalize interest rates and open the capital account while maintaining fiscal discipline. It’s a tall ask. It would suggest that some objectives like the internationalization of the Rmb be deferred.

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