In the midst of an intense global economic slowdown that began in 2008, China's economy amazingly appeared to be unaffected. Defying the world-wide real estate collapse, China's GDP grew by an impressive 8.7% in 2009. Fueled initially by a $586 billion stimulus package, China would end up plowing and additional $20 trillion dollars into a fixed asset bubble that was designed to produce the government's desired GDP print.
Perhaps inspired by the movie "Field of Dreams", the Chinese government believed in the adage "If you build it, they will come". And for the next 6 years China built empty cities in spades. New construction remains mostly unoccupied to this day; estimates are that 52 million homes are vacant and 90% of those empty units were purchased strictly for investment purposes.
Apartments were snapped up as investments by the nation's wealthy upper and middle classes, then sat empty as the owners failed to find tenants who could meet the pricey rent.
Investors sat on massive mortgages on unoccupied real estate holdings and home prices began to fall when loans from the shadow banking system started to dry up. This caused the Chinese authorities to quickly search for another bubble to create; one in a more convenient and easily manipulated asset class. If the average citizen could no longer afford to buy a house why not try to create a wealth effect by putting equities in a perpetual bull market?
Substituting empty cities for brokerage accounts with little capital, on-line Chinese lenders set up margin accounts with the same fervor as U.S. sub-prime mortgage lenders in 2006. In addition to conventional brokerage accounts, 40 online lenders helped arrange more than 7 billion yuan worth of loans for stock purchases in the first five months of 2015. Lending volumes surged 44% from April to May alone.
China's margin finance problem quickly reached epic proportions. Margin trading jumped thirtyfold over the past three years on the Shanghai stock exchange. Chinese margin debt has risen 123% year-to-date, reaching a new record of 2.3 trillion yuan ($370 billion) on June 18.
However, some analysts believe the real amount of money borrowed by Chinese investors is likely to be much higher. The amount of shadow margin financing, which includes umbrella trusts and stock-collateralized loans, in the mainland stock market could easily be double or triple that of the balance of conventional margin financing taken through brokerages.
In addition, unlike other major international stock markets, which are dominated by professional money managers, retail investors account for around 85% of Chinese trading.
For a brief moment it was a magical solution to combat the failed real estate bubble. The Shanghai Composite started 2015 at 3,234 and hit 5,023 on June 4th--a 150% surge from the preceding 12 months, before plunging to 3,800 where it sits today.
But the market is still far from trading at a discount valuation. Despite the recent carnage, Shanghai shares are trading at 57 times earnings. That's down from the June price to earnings ratio of over 100, but it's still 3x higher than the PE ratio of the S&P 500.
The totalitarian regime is making daily policy modifications in a desperate attempt to stem the fall. But, interest rate reductions by the People's Bank of China (PBOC), cuts in reserve ratio requirements and relaxations in margin trading rules have done little to calm investors so far.
Brokerage firms and fund managers have now vowed to buy massive amounts of stocks aided by a direct line of liquidity from the PBOC, which is directly monetizing securitized loans from China Securities Finance Corporation (China's state-backed margin finance company.)
The nation is also trying to coerce corporate officials to buy back their own shares to a great degree. But with China's questionable accounting practices and stocks prices completely decoupled from fundamentals, this is a little like asking Jim Jones to drink his own Kool Aide. In addition, China has promised to investigate "malicious" shorting of stocks (basically banning short selling unless you want to be a guest in the communist government's prison system) and has banned selling of shares outright from any shareholders that own at least a 5% stake in a company.
And, to make matters even worse, over 50% of stocks in the primary Shanghai Exchange are in a trading halt. Just imagine how much further down the stock market would be if these shares were allowed to freely trade. Given all this it is a travesty to believe there is actually a stock "market" in China any longer. Perhaps the Chinese government will be able to manipulate stocks from going down much further but it will be powerless to prevent the ultimate collapse of its phony economy.
The current debacle in China is actually much worse than the U.S. equity collapse in 1929 and the Japanese economic bubble in 1989. Despite what the Carnival Barkers on Wall Street are saying, the Chinese economy is now suffering from the evaporation of the wealth effect. New Chinese millionaires, bolstered by their newly found stock market wealth, had been fueling the consumption economy that was supposed to supplant its export-driven growth model.
After a stock-market rout that has erased about $3.2 trillion in perceived value, car sales in June were down 3.2% month over month. This is the first such decline in over 2 years and refutes the claim that China is still growing at the fictitious 7% growth rate the government has sought to produce.
Once the darling of the Keynesian utopian dream, a booming China spoke to those who believed that the power of a command and control economy was far more effective than the power of the free market.
As the Chinese communist economic regime begins to unravel, the bubble in the belief that a small group of central planners can make better decisions than millions of people acting freely in their own self-interest should burst along with it. And the current massive bubble in the credibility of Central Banks to save every market should suffer a welcomed blow as well.
The Chinese are communists masquerading as capitalists. They have no idea what a free market is; instead they have layered an artificial equity bubble on top of a manufactured real estate bubble. And now are busily trying to command both bubbles to perpetually float.
Make no mistake, China is by no means alone in their disdain for free markets and its willingness to create a facade of prosperity at all costs. The governments and central banks of Japan, Europe and the United States have also eviscerated the price discovery mechanism in all asset prices. What we have left are worldwide asset bubbles floating on top of synthetic economies, which has somehow caused -- in lobotomized fashion -- a universal confidence in governments to borrow and print our way to everlasting prosperity.
These Potemkin central banks will be able to erect only hollow economies built with counterfeit money. Therefore, you must build a strategy that will profit from the inevitable fate of these economies, which is intractable inflation and a protracted depression...at least until governments embrace the power of free markets once again.