China's financial world has officially entered the paranoia zone. As the Shanghai stock market experiences its worst three-week rout since 1992 -- in defiance of government efforts to reverse the plunge -- government officials are blaming shadowy conspiracies for the sell-off.
One narrative whipped up by state-run media has nefarious overseas forces driving down shares to embarrass President Xi Jinping and stymie China's development. Another conspiracy theory suggests that rumor-mongers are driving shares lower in order to profit from short selling. That's prompted regulators to pledge a crackdown on "vicious" short sellers: Just ask Morgan Stanley, the recent subject of "hidden agenda" allegations by mainland media for voicing bearish views on the trajectory of Shanghai shares.
The problem is investors now recognize that China's years-long rally was based more on hype than fundamentals, and they're looking to reduce their exposure. But rather than deal with that reality, Xi's team has been feverishly resisting it, including with interest rate cuts, a moratorium on initial public offerings, and a stock-buying fund.
Beijing has shown it's willing to throw any possible solution at the problem of falling stocks -- but its effort to blame foreigners and short sellers is a sign of true desperation. Data show very clearly that foreign money managers control fewer than 3 percent of Chinese shares. Those overseas forces Beijing sees fit to demonize? They've actually been adding to holdings as prices tumble. Short selling, meanwhile, is far from epidemic on Chinese markets. As of Thursday, the day before media attacks accelerated, short positions accounted for just $314 million of trades on the Shanghai exchange, less than 0.03 percent of China's market capitalization.
Shanghai's reckoning has pundits grasping for lessons from past financial crises. Much is being made, for example, of China's "House of Morgan" moment. As Wall Street crashed in October 1929, five top financiers met at the New York offices of J.P. Morgan and pooled resources to support prices; on Saturday, 21 Chinese brokerages did something similar, pledging more than $19 billion to a stock-buying fund. If Monday's events are any guide, they may have to add a zero to that sum. While shares of the largest state-run companies rose, most Chinese stocks fell anew, and the ChiNext measure of smaller companies sank 4.3 percent.
China's embrace of the blame game has a more recent crisis written all over it: Asia's 1997 meltdown. The most vocal practitioner then was Mahathir Mohamad, Malaysia's prime minister, who blamed foreign speculators like George Soros for his country's woes. Mohamad argued that Soros and his ilk, after breaking the Bank of England by shorting the British pound in 1992, had turned their sights on Malaysia, Indonesia, South Korea and Thailand. In the years that followed, officials in Manila, Taipei and Tokyo regularly took aim at foreign traders with supposedly sinister intentions of hurting their markets. The relentless search for scapegoats allowed these governments to avoid pursuing painful, but necessary economic reforms.
There's a more salient lesson Xi's team should learn from 1997. Just like Bangkok, Jakarta and Seoul 20 years ago, Beijing is supporting economic growth and asset prices by directing state-run banks awash in bad loans to lend more. Credit better marshalled into the private sector is instead being channeled to public works and industries plagued with overcapacity. The only things holding China's stimulus machine together are the closed nature of its financial system and a currency essentially pegged to the dollar.
That was also true of other Asian countries in the 1990s -- until those governments lost control of the narrative in markets. As more and more investors got wise to the depth of deflationary forces and preponderance of unproductive investments, they fled. It wasn't the media fueling panic, nor villainous foreign investors; it was the sudden arrival of reality -- an understanding that the fundamentals supporting asset prices were illusory.
This is where China finds itself today -- not in the throes of some giant financial conspiracy, but an inevitable reckoning with the realization that stocks sustained by government propaganda have nowhere to go but down. The $3.2 trillion of losses so far will continue until Xi convinces investors he's taking steps to strengthen China's economic fundamentals. Unfortunately, the Chinese government still seems more interested in battling fictitious plotters than grasping the real plot.
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