Shanghai's stock market just experienced a Wile E. Coyote moment. For weeks, investors had been chasing higher and higher returns. On Wednesday, however, they suddenly looked down to find their road had disappeared.
The realization came courtesy of China's central bank, which had decided to drain cash from the financial system, and jittery brokerages, which had just tightened lending restrictions. That one-two punch didn't just send Chinese stocks down 6.5 percent, the most in four months. It also raised existential questions about one of modern history's greatest asset bubbles.
And it is a bubble. The 127 percent gain in the Shanghai Composite Index over the past year defies financial gravity. It's been driven not by optimism about China's economic fundamentals or corporate earnings, but record growth in margin debt. Such lending -- fueled by speculation that the People's Bank of China will soon cut interest rates and reduce lenders’ reserve requirements -- exceeded $322 billion as of May 27, five times the level of a year earlier. And that's just the official tally: China's shadow banking system is estimated to have created $20 trillion of credit since Lehman Brothers went bankrupt in 2008.
What makes China's bubble unique is the government's direct role in creating it, feeding it and now managing it. Last August, for example, as the Chinese stock market threatened to sag, state-run media started prodding the Chinese public to pile their life savings into shares. During a single week in August 2014, Xinhua News Agency put out eight features espousing the wisdom and patriotism of owning equities. Beijing also reduced trading fees and allowed individuals to open as many as 20 accounts. The implicit message was that the Communist Party could and would protect stock investments, if need be.
The plan succeeded beyond Beijing's wildest expectations, leaving it with an epic challenge: How do you deflate a giant bubble without enraging the masses or losing control of the economy?
China, the world's second largest economy, is now in completely uncharted territory, struggling with a huge and unsustainable market that it can't allow to crash. (At the same time, China is dealing with an explosion of public debt, with local government IOUs now amounting to about $4 trillion.) China must decide whether to tolerate further losses in shares or intervene to support the market.
It's possible, of course, that Wednesday's drop was just a temporary correction. After all, the Shanghai gauge climbed as high as 4,986.50 Thursday, almost reaching the 5,000 level for the first time since 2008.
But it seems more likely that traders will soon realize Shanghai shares aren't on solid ground. And that will put Beijing in a very difficult position. Having failed to build a stable, vibrant financial system organically, China could soon be facing its long-feared financial reckoning. And if an economy the size of China's finds itself going off a cliff, the rest of the world should brace for impact.
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