Last June, China’s stock market miracle ended in tears.
The SHCOMP’s inexorable, parabolic ascent was to a large degree facilitated by an explosion of margin debt, the likes of which could not be found in any other major market across the globe. For instance, by the end of June, the outstanding balance of margin transactions as a percentage of the SHCOMP’s free float market cap was nearly 14% compared to just 5.5% for the S&P and less than 1% for the TOPIX.
A dramatic unwind in the half dozen backdoor margin lending channels that had funneled an additional CNY1.5 trillion into equities brought the party to a thunderous end and by late July, the market was off by more than 30% from its peak.
Chinese officials had already begun to panic by mid-month and then, on the 27th, the bottom fell out.
A harrowing bout of late day selling led the SHCOMP to post its worst one-day drop since February of 2007 and its second worst single session decline in history as the market collapsed by 8.5%.
More than two-thirds of stocks in the index traded limit down that day.
At that point, China was out of ideas. It had been nearly three weeks since Beijing announced it would inject capital into China Securities Finance Corp., effectively giving the PBoC a mandate to not only underwrite brokers’ margin lending businesses but in fact to buy A-shares directly, and nothing seemed to be working to arrest the slide.
Indeed, starting on June 27 (by which time the Shenzhen had fallen by more than 20% from its peak) the PBoC unleashed an eye watering array of measures that encompassed everything from an RRR cut to the easing of regulations to state mandated investments by pension funds to verbal interventions in the form of threats against “malicious” shorts. Nothing was working.
At a loss, the PBoC’s New York-based chief representative for the Americas, Song Xiangyan fired off an e-mail on the morning on July 27 to the institution China figured knew the most about propping up markets: the Fed.
Just after 11 a.m. ET, the e-mail appeared in the inbox of senior Fed staffer Steven Kamin. The subject line read as follows: “Your urgent assistance is greatly appreciated!"
"My Governor would like to draw from your good experience,” Song told Kamin, the director of the Fed's International Finance Division. "Could you please inform us ASAP about the major measures you took at the time?,” Song asked.
Song was referring to what the Fed did to try and allay market fears in the wake of Black Monday when the S&P collapsed 20% on October 19, 1987. Reuters obtained the messages between Song and Kamin via an FOIA request.
“We’ll try to get something to you soon,” Kamin told Song.
“What followed five hours later was a 259-word summary of how the Fed worked to calm markets and prevent a recession,” Reuters writes, adding that “Kamin also sent notes to guide PBOC officials through the many dozens of pages of Fed transcripts, statements and reports that were attached to the email.”
Those documents, Reuters goes on to note, had all been publicly available on the Fed’s website for years and “detail how the Fed began issuing statements the day after the market crash, pledging to supply markets with plenty of cash so they could function.”
Apparently, Song was especially interested in the Fed’s use of repos to inject cash. “In 1987, the Fed contacted banks directly and encouraged them to meet legitimate funding needs’ of their customers,” Reuters continues, recounting more details from Kamin's email to Song. “In addition to its pledges and cajoling, the U.S. central bank in 1987 eased collateral restrictions on Wall Street and tried to calm markets by intervening in trading earlier than normal.”
But US officials did more than that. They also created the PWG or, "the President's Working Group on Financial Markets," or, as we know it, the "Plunge Protection Team." The group was created by an executive order from the Reagan White House in the wake of Black Monday and officially serves as a kind of consortium of top officials who advise the White House on markets when something goes horribly awry. Unofficially, the group directs, facilitates, and otherwise engineers futures buying to support the market. Or so "conspiracy theorists" believe.
As Reuters concludes, "it is unclear if [the Fed's help] played a role in shaping Beijing's actions." Right. But what is clear is that when it comes to central bank intervention, the PBoC thinks the Fed has plenty of experience from which to draw dating back specifically to the 1987 crash that precipitated the creation of the body which nowadays operates from 33 Liberty and directs its barely-arm's-length trading division at Citadel when someone needs to step in and "provide" a bit of ES liquidity.
If these were the messages exchanged between lowly "senior staffers" at the Fed and PBoC, one can only imagine what higher level talks might have come later because as you might recall, things got much, much worse for China after July 27. If China's subsequent plunge protection efforts in any way reflect something they learned from the Fed, then there may be a book full of equities sitting around on a secure server in the basement of the Eccles Building that no one's ever seen. But as noted above, Yellen and Dudley have plenty of leveraged proxies when they think the market might be a bit short on "liquidity."
Finally, we would note that if China intends to adopt the post-Black Monday Fed playbook, we're in for two decades of lunatic monetary policy characterized by unnecessarily low rates and the deliberate perpetuation of the myth that fantastic wealth is simply a matter of multiple expansion. Perhaps we'll even see the institution of the "Zhou put."
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For those who might have missed it, here's Deutsche Bank's note from last summer discussing the "mythical" plunge protection team and comparing 1987 to China's market rout
The '87 US plunge protection team: sweet & sour lessons for China
Unlike 1987 when Greenspan was a one-man plunge protection team using rate cuts to support the market, China has fewer constraints to substantive direct price keeping operations, but there are strong arguments against actions going beyond smoothing activity.
The PBOC is struggling with ‘the holy trinity’ - maintaining a currency peg for stability, targeting interest rates and RRR directed at the real economy, providing equity support, and all this while attempting to liberalize interest rates and open the capital account. It’s a tall ask. Internationalization of the currency should be slowed.
The sweet
1) The slide in Chinese equities has some characteristics of the US 1987 crash in so much as ’the October crash’ in 1987 unwound relatively short-term gains mostly established in the prior 10 months. As per Figure 1, the one-year prelude to the 1987 US crash showed a similar pattern to China equity gains, albeit Figure 2 also shows how China’s equity appreciation was much larger than the US gains that immediately preceded the 1987 crash. The important point is the equity surge was relatively shortlived, so there never was quite enough time for a feedback loop to develop from higher asset prices driving a stronger real economy driving the asset bubble ever higher. The real economy implications are not as acute when a short-lived bubble pops.
2) Remember the mythical ‘plunge protection team’. The market has consistently spoken about how the 1987 crash prompted the creation of a ‘crisis group’ of senior US officials that would draw up lines of support for the equity market if faced with a similar collapse in equity prices. For better and worse, China is much more willing and has fewer constraints on official intervention, and the role of the PBOC funding China’s Securities Finance Corp as a source of support notably for a small cap stocks, at a minimum has the prospect of smoothing any price decline.
The sour
1) 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. This has resulted in good stocks/assets being sold to hedge illiquid asset exposure that itself destroys confidence even as it creates good value for select equities. China has the resources to support the equity market in the shortterm, but there are inherent problems in artificially supporting prices. It undermines the markets 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.
2). The US substituted a late 1990s equity bubble with a housing bubble which did not end well. China’s experiment in substituting housing froth with equity froth, is plainly not succeeding.This all falls under the title: ‘troubles with policy traction’ that adds to China’s growth risks.
3). Collateral damage. The problems of credit creation dominated by bank lending is compounded by the sizable part of lending that is backed by property and a much smaller but substantial amount of collateral comprised of ‘movable’ assets like equities, commodities, and receivables. There is then more scope for contagion to work across asset classes and intercede directly into the banking system via the impact on collateral. This space needs to be watched closely.
4). ‘Proof’ that the PBOC is not omnipotent. 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 RRR 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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Bonus: Text of Executive Order 12631
Executive Order 12631--Working Group on Financial Markets
Source: The provisions of Executive Order 12631 of Mar. 18, 1988, appear at 53 FR 9421, 3 CFR, 1988 Comp., p. 559, unless otherwise noted.
By virtue of the authority vested in me as President by the Constitution and laws of the United States of America, and in order to establish a Working Group on Financial Markets, it is hereby ordered as follows:
- Section 1. Establishment. (a) There is hereby established a Working Group on Financial Markets (Working Group). The Working Group shall be composed of:
- (1) the Secretary of the Treasury, or his designee;
- (2) the Chairman of the Board of Governors of the Federal Reserve System, or his designee;
- (3) the Chairman of the Securities and Exchange Commission, or his designee; and
- (4) the Chairman of the Commodity Futures Trading Commission, or her designee.
- (b) The Secretary of the Treasury, or his designee, shall be the Chairman of the Working Group.
- Sec. 2. Purposes and Functions. (a) Recognizing the goals of enhancing the integrity, efficiency, orderliness, and competitiveness of our Nation's financial markets and maintaining investor confidence, the Working Group shall identify and consider:
- (1) the major issues raised by the numerous studies on the events in the financial markets surrounding October 19, 1987, and any of those recommendations that have the potential to achieve the goals noted above; and
- (2) the actions, including governmental actions under existing laws and regulations (such as policy coordination and contingency planning), that are appropriate to carry out these recommendations.
- (b) The Working Group shall consult, as appropriate, with representatives of the various exchanges, clearinghouses, self-regulatory bodies, and with major market participants to determine private sector solutions wherever possible.
- (c) The Working Group shall report to the President initially within 60 days (and periodically thereafter) on its progress and, if appropriate, its views on any recommended legislative changes.
Sec. 3. Administration. (a) The heads of Executive departments, agencies, and independent instrumentalities shall, to the extent permitted by law, provide the Working Group such information as it may require for the purpose of carrying out this Order.(b) Members of the Working Group shall serve without additional compensation for their work on the Working Group.(c) To the extent permitted by law and subject to the availability of funds therefore, the Department of the Treasury shall provide the Working Group with such administrative and support services as may be necessary for the performance of its functions.
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Summary of China's efforts to prop up the market