補倉("Bǔcāng") = Margin Call

by: Ivan Martchev

A typical fortune cookie would likely carry an encouraging and positive message, like: "Meeting adversity well is the source of your strength." Or, "A dream you have will come true." Better yet, "Our deeds determine us, as much as we determine our deeds." I have heard way too many of those slogans as my daughter reads them out loud as she feeds the fortune cookies to my dog, Doxie the dachshund, who has never really cared for the paper cliches, although he has definitely acquired an appetite for the vanilla-flavored cookies.

If you flip the tiny strip of paper, there is typically another message on the other side. It often says: "Learn Chinese" along with some Chinese characters, their phonetic pronunciation, and an English translation.

It seems that through a printing glitch in China few weeks ago, all fortune cookies had a more nebulous message printed: "Be on the lookout for coming events; they cast their shadows beforehand." On the other side, for the benefit of fortune cookie connoisseurs who do not speak the language, it said:

Learn Chinese: 補倉 (Bǔcāng) -- Margin Call

I like to think that this may have happened on June 12, the day the Shanghai Composite hit its recent multi-year high of 5178.19. The index closed last Friday at 3686.92, down 28.8% in three weeks.

This is a crash:

Shanghai Composite - Daily OHLC Chart

Source: Barchart.com.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Earlier this year (on April 27), when this train of greater fools, aka the Shanghai Composite, was gathering momentum, I had to use less absolute language, like "The Chinese market may crash." I don't need to do that anymore as it has crashed indeed. This is a fact. Here is why it may crash some more.

The Chinese financial system is operating on record leverage at a time when the real estate market has seen a decisive downturn from record highs. In some respects, China today is where Asia was in 1997, the U.S. in 2008, or better yet, in October 1929. The Chinese government seems to believe that it can intervene against any market or cure any economic weakness. This time it actively encouraged the parabolic rise in stocks as a means to offset the weakness in the economy resulting from the decline in the real estate market, which by the way, is still deflating.

The Chinese government, which a famous emerging markets strategist used to call "the cadres," tried to substitute one bubble (in real estate) for another (in stocks). This maneuver has resulted in the unfortunate outcome where now the cadres will have to deal with two ongoing crashes simultaneously, one in real estate and one in stocks. This dual crash situation, combined with the likely increase in problems in the Chinese banking system is likely to push the economy into a bad recession, in my opinion.

The cadres tackled the 2008-2009 weakness in demand for Chinese goods by forced lending. That did support the Chinese economy, but at what cost?

Debt to Gross Domestic Product Ratio Chart

Source: Bloomberg.com.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Since the last time we had a bubble in the Shanghai Composite in 2007, the Chinese total debt to GDP ratio has risen from 158% to 282%. Keep in mind that Chinese GDP has nearly tripled since that time. The interesting dynamic here is that as the economy grew at a breakneck pace, total financial leverage in the economy grew much faster, hence the expanding debt-to-GDP ratio. I don't think official financial leverage estimates take into consideration the shadow banking system, where unregulated lending has grown even more dramatically in the past 5 years.


Source: The Brookings Institution.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Some estimates from JP Morgan put shadow banking at 81.2% of 2013 GDP. Given how fast regulated debt growth has exploded since the end of 2013 and the crackdown on regulated lending that Chinese regulators have done since, it is entirely possible that the unregulated shadow banking sector has surpassed 100% of GDP by the middle of 2015 as corporate and government entities that could not get regular loans increasingly turned to the shadow banking system. This debt overhang may lead to hellish consequences as the real estate market keeps deflating and the stock market keeps unraveling.

Margin Loans fuel China Equity Rally Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The trouble with the Shanghai Composite is that it is experiencing the cascading forced selling that is customary when large amounts of leverage are used. A margin call is a margin call. To the Chinese it may be a bǔcāng, but it does result in the same forced selling there that it does all over the world. I observed with great interest how the leverage was mounting in this parabolic rise of the Chinese markets and it was not all that difficult to see that it was going to end badly. On April 1 of 2015, Bloomberg reported that:

The outstanding balance of the margin debt on China's smaller exchange in Shenzhen was 502.5 billion yuan on April 1. That puts the combined figure for China's two main bourses at the equivalent of about $242 billion. In the U.S., which has a stock market almost four times the size of China's, margin debt on the New York Stock Exchange was about $465 billion at the end of February.

What Bloomberg did not report that day is that the infamous Chinese shadow banking system had infiltrated the stock market and that provided margin debt to the tune of 500 billion to 1 trillion yuan. Since it is unregulated, nobody has the faintest idea what the exact number is. If the shadow banking system is indeed at 100% of GDP, the number could theoretically be well past 1 trillion yuan. The reason why the Shanghai Composite is unraveling so fast is that unregulated margin leverage extends past 5X, unlike its regulated version that stops at 2X. At 5X leverage, a 30% decline is already a wipeout.

The trillion yuan question is, what happens next?

Over the weekend, we learned that Chinese brokers are setting up a $19 billion fund to stem the market rout. I laughed at the headline number, as this amount is about the same size of a single large U.S. mutual fund and a rounding error compared to the $2.4 trillion that has already disappeared, courtesy of the fascinating use of leverage. The Chinese have halted IPOs. I would not be surprised if the PBOC will be buying futures and ETFs next (the BOJ is quite fond of the latter in the Japanese market as we speak).

1990 Japanese Crash Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Because of the leverage employed, this Shanghai drama is likely to look more like the Dow in 1929, when some traders leveraged their stock trades to the tune of 10X. Or perhaps it will be more like the Nikkei in 1990. The Asians tend to be the ultimate momentum traders, so the dynamics may be similar.

The larger point is that the Shanghai Composite just crashed and we are far from seeing the ultimate market low, which may be a year to two from now. If the Chinese economy de-leverages, I think we could see a very bad recession. I know that the cadres feel they can nip this in the bud the way they did with their forced lending strategies in 2009, but I've got two words for the cadres: Margin call.

Gruyere Souvlaki

On Sunday night the Greeks voted "όχι" ("no") in support of their Prime Minister Alexis Tsipras and his bid to end austerity. The currency markets are open and the euro is taking this as a negative for the euro-zone so far, as market participants feel that this vote increases the likelihood of Greece leaving the euro. The German Dax futures are only down marginally compared to how they acted the previous Monday, right after this glorious referendum was announced the previous weekend.

On this memorable day for Hellenic democracy, when the government called a referendum on whether it should pay its debts, it is clear that ordinary Greeks feel betrayed and bewildered. It is not well known to non-speakers of the Hellenic language that the simple words for "no" (όχι, pronounced "ohi") and "yes" (ναί, pronounced "ne") used on the ballot can be very confusing. In most Slavic languages, spoken in the countries neighboring Greece, the Slavic word for "no" (or "не," phonetic "ne") is pronounced precisely like the Greek word for "yes" (ναί, phonetic "ne"). So, if the Greek for "yes" means "no" to a whole lot of their neighbors, it is no wonder that Hellenic diplomacy has trouble making progress on more complicated issues related to its membership in the euro-zone.

Euro Fx United States Dollar - Daily OHLC Chart

Source: Barchart.com.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

What does "όχι" mean anyway, even to the Greeks?

I know that the Greeks want to have their free gyros and eat them too and that to them the όχι vote does not necessarily mean leaving the euro. What is more relevant is how the euro-zone powers-that-be, led by Germany, view the όχι vote. To the Germans, it is unthinkable to keep lending to a fiscally irresponsible country so that it can maintain a standard of living that it could never achieve on its own.

In the end, with Greek banks closed for most of the past week and rationing euros to pensioners and depositors in morsels, it all comes down to the European Central Bank. The ECB is holding a sharp sword to the throat of the Greek banking system and it could collapse it at whim via the removal of further Emergency Liquidity Assistance injections, which so far have been frozen at 89 billion euros (about $100 billion). When the ECB stopped giving Greek banks more money last week, they closed. What happens if the ECB refuses to release more funds? Does the troika really want Greece to collapse?

Greek Drachma Image

The Greeks are betting that the troika does not want the fall of the Hellenic financial system and therefore they will succumb to better terms on a new bailout plan that has yet to be negotiated. Much better terms in a speedy bailout will be seen as a defeat to the troika, which is why it's likely not coming.

A Cyprus-type scenario with bank closures, deposit haircuts, and some sort of a debt restructuring may be a possibility. It is also possible that this prolonged bank holiday resulting from the tightening of the ECB's monetary vise will topple the Syriza government (although with a 61% "no" vote, Syriza surely feels that it has maintained its mandate to rule the country). And then there is the Grexit, when the glorious drachma (pictured above) replaces the euro and Greece likely leaves the European Union.

As of Sunday night, all of the above scenarios are still possibilities. They could become probabilities as the week unfolds.

All over Athens, real-life reincarnations of taverna proprietors like Mr. Gus Portokalos must be worried. Mr. Gus Portokalos may be a fictional character from a popular comedy, but it is my experience that real-life tavern proprietors in Athens are much like him. The banks have been closed for over a week and they have no money to buy feta cheese, which is a staple of Hellenic cuisine and a key ingredient in the popular Greek dish souvlaki, but no one is coming to help.

Upon learning of the feta shortage, embattled Prime Minister Alexis Tsipras scratches his head, ponders the difficult decisions that heads of government all over Europe have had to make for their peoples over the centuries, and remembers how Marie Antoinette handled a similar issue during the French Revolution. He personally calls Mr. Gus Portokalos and after an exchange of pleasantries he brilliantly notes:

"If there is no feta, let them eat Gruyere."

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