China's Ministry Of Public Safety's Unsafe Practices

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Includes: CHN, CN, CXSE, FCA, FXI, FXP, GCH, GXC, JFC, MCHI, PGJ, TDF, XPP, YANG, YAO, YINN, YXI
by: Faxbot

Summary

What would happen when the market collapses and the government prevents large block sell transactions from executing? The answer: many things, but mostly bad.

China's Ministry of Public Safety's intervention on selling to stem losses creates stability issues.

Emerging market funds may be forced to sell quality assets to settle investor redemptions in the market.

Higher fund outflows could result in a vicious cycle where redemptions feed additional market weakness in the short term.

Today, I would like to focus on consequences pertaining to funds that cover emerging markets, more specifically, those that have Asian holdings. These asset classes when broken down include, but are not limited to: concentration of assets from higher quality bonds to riskier stocks from the Asian equity markets. They may also hold multinational companies which operate in the region. Each fund is driven by a model that dictates meticulous balancing in the face of market forces, redemptions, and more recently, China's Ministry of Public Safety.

Since mid-July, Chinese regulators have imposed a ban that would keep major shareholders of companies from exiting (selling stock) for six months and have gone so far as to intervene with large block sell orders, not limited to just short sales during darker periods. Though the latter has eased up of late, the precedent has been set and will be on minds of asset managers and international investors going forward.

Why? In the case of a bearish market event, where fund managers are facing redemptions and early withdrawals, they are not guaranteed to freely execute orders across the board to settle with their own customers. In an emergency, the managers may be required to force liquidation of higher quality assets rather than sinking, but government blocked, Chinese companies. This could lead to a chain reaction and a general selloff, as multinational corporations and other assets held mutually by domestic and international funds would have to adjust via automated trading.

To get in front of this, steps will have to be taken to ensure the survival and an orderly unwinding of a fund should the worse happen. This would include possibly, but not limited to:

  1. An immediate halt on further capital going into Chinese assets - this would also hurt a potential market recovery.
  2. Slow liquidation, if possible, of current Chinese assets that are not vetoed by the central planning committee and are not subject to the major shareholders' ban.
  3. A broad and indiscriminate reduction of all other assets and vehicles to maintain the strategy of the fund model.

Implementing these changes cannot happen overnight, over a week, or even over a month. Mutual funds are large colossal pools of money with large foot prints. To exit even small percentage holdings takes many transactions over time, otherwise they would create big waves.

On August 11, China devalued their currency to support their exports. Although the market losses (in the US) from the fallout reversed in the following days, it was definitive confirmation that China is struggling. Those paying attention would promptly head for the door.

When a worried investor heads for the door and calls up their mutual fund for redemption, the fund has 7 calendar days to raise the money and return it to the client. The wake of such a move can be seen by the selloff on August 17 and August 26. Lipper reports outflows of $412 million from emerging market funds reported for the week ending August 19. (Weekly reports of the August 26 time frame are not yet published at the time of this article's submission.)

Further panic will drive more investors towards the sidelines, as fund managers struggle with the oncoming wave of redemptions. Pay close attention to the fund outflows for the following couple of weeks.

Conclusion

Government intervention of market mechanics can lead to calamitous long-term instability and could trigger a global selloff. Be prepared to see an acceleration week to week in fund outflows, leading to further downside as fund managers are forced to liquidate and rebalance portfolios.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.