In desperate need of oxygen.

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Stock Boom Chokes China's Reform Plan

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In the past 12 months, China's stock boom has created $6.5 trillion, equivalent to more than two-and-a-half times the U.K. economy. That sum could fund 65 Asian Infrastructure Investment Banks, buy Apple eight times or rid South Korea of its household debt problem seven times over. It amounts to the greatest stock rally in history.

But as the spoils get counted, it's important to consider the costs. The biggest one is President Xi Jinping's economic reform program.

Lost amid the superlatives about the Chinese stock boom is how the country's bond market has suffered because of it. China has loads of debt -- the $4 trillion issued by local governments alone exceeds Germany's economy -- but lacks a functioning secondary market that can act as a shock absorber in times of financial turmoil. Xi seems to understand that stimulating demand for bonds will be the key to avoiding a devastating debt crisis, and, to that end, the Chinese government has unveiled a plan to swap local-government loans for lower-yielding securities. China's central bank, meanwhile, is boosting credit to recapitalize provinces and increase demand for their assets.

The stock boom, however, is interfering with these plans. The more the stock exchanges in Shanghai and Shenzhen surge, the less interest traders have in bonds. In fact, there's an ongoing run against funds that buy debt at all: Bond funds and wealth-management products have suddenly been overwhelmed, at the worst possible moment, by redemption pressures.

Municipal bond issuance is expected to reach $285 billion this year, four times as much as in 2014. Those sales will include securities that are supposed to allow local government to exchange at least $161 billion of maturing high-cost debt. But it's possible no buyers will show up, thus killing a vital reform initiative in its infancy.

The absence of active markets for corporate, mortgage- and asset-backed securities and tax-exempt IOUs offers corporate China only one real option for raising capital: initial public offerings that blow the country's stock bubble even bigger. But the absence of a healthy bond market could create wild swings not only in Chinese equities, but the country's broader economy. Asia's 1997 crisis demonstrates how. As stocks plunged that year, the region had few liquid debt arenas, so investors felt they had no choice but to flee for other markets in order to swap their assets. The resulting capital flight toppled several Asian economies.

You'd think that with Shanghai and Shenzhen shares up 152 percent and 185 percent in 12 months, investors might be interested in diversifying into AAA corporate bonds. You'd be wrong. Mainland trading is being driven by sheer momentum, not rational investing strategies. Yesterday, stocks barely reacted to data showing deflation is on China's horizon; nor have they shifted in response to news that producer prices fell 4.6 percent in May.

Beijing bears some responsibility for the stock market bubble. Part of the reason individual investors have been racing to open trading accounts -- an unprecedented 4.44 million new stock accounts in the week ended May 29 alone -- is they have reason to believe the Chinese government is determined to keep stocks racing upward. Beijing has been considering allowing brokerages to roll over margin trading contracts, a sign it wants shares even higher.

China has played host to financial bubbles before, including the property and credit bubbles that Beijing blessed in the aftermath of the global financial crisis. But the stock surge is arguably the most dangerous one yet, as hundreds of millions of mainland investors leave the country's most pressing economic needs entirely neglected. China's ailing bond markets has made it more difficult for Xi to repair regional-government balance sheets. They may also sap the government's confidence when it comes to tolerating the big debt defaults needed to chasten runaway borrowing.

Beijing could always curtail its support for equities, of course. That might increase demand for bonds might increase and invigorate Xi's plans for a more vibrant and mature financial system. But, for now, Chinese authorities still seem content to continue filling the punchbowl -- and traders seem more than content to keep drinking from it.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Willie Pesek at wpesek@bloomberg.net

To contact the editor on this story:
Cameron Abadi at cabadi2@bloomberg.net