Despite much sounding of trumpets and spreading of rose petals, neither Greece nor China have proven ready for their star turns on the world economic stage. Greece’s inability to repay its debts and China’s struggles to create its own version of open stock markets sent global markets into a tizzy over the past few weeks. Though vastly different in in terms of scale, history, prospects, competence, and a million other ways, the present Greek and Chinese capital market crises have their roots in policies carefully crafted over the past two decades meant to bring about the integration of their respective economies into that of the wider world. From our point of view, the Greek effort appears to be a complete and irretrievable failure, while China appears to have been a false start.
The full integration of Greece into the European Monetary Union 2001 was to herald the beginning of a new golden era for Greece as well as Europe. Membership in the club meant that Greece could issue national debt in a currency in common with Germany, France, and other European economies, presumably back by the full faith and credit of those other nations, thus allowing the Greeks to both borrow more and at a cheaper rate than their rather consistent history of defaults would otherwise suggest. And borrow they did over the course of the next 8 years, to the tune of €300 billion, or about 120% of annual Greek GDP.
And while the capital flowed in, the Greek government’s expenditures grew at an even faster pace, not just for infrastructure, but also for wildly generous retirement terms and benefits, in addition to staggering wage levels for government employees. The wheels finally came off in the summer of 2010 and the Greek economy has been in 7 continuous years of recession or anemic growth with GDP shrinking by 25% since 2008 and 1 in 4 Greeks unemployed, a level not seen in the U.S. since 1933. Many Greek creditors have taken haircuts of 50% or more on their holdings as part of the 2010 and 2011 Greek bailouts. And yet, the Greeks still have €300 billion of outstanding indebtedness and, because their GDP has fallen by 25%, their debt now constitutes 180% of their annual GDP. It is fair to say that the Greeks are in even worse shape than when the bailouts started back in 2010.
It is perhaps ironic, perhaps justice, that Greece finds itself the embodiment of democracy’s long-purported Achilles Heel: the potential for voters to vote themselves straight into bankruptcy. Indeed, the 61% of the Greek populace which voted against accepting the EU, ECB, and IMF bailout terms on July 5, 2015 will serve as a shining example of this oft-pondered flaw in popular rule. The irony is that the terms resoundingly rejected by Greek voters turned out to be far less onerous than the terms the two sides subsequently negotiated: in return for €86 billion of new loans, because nothing solves a debt crisis like more debt, the Greeks have tentatively agreed to sell €50 billion of state-owned assets, reform the Greek retirement and wage systems, i.e. raise the retirement age of hairdressers above 50, increase its sales tax from 13% to 23% (because nothing encourages retail activity like higher prices), as well as impose a 5% “solidarity surcharge” on personal income ( the most likely outcome of which is to increase the gap between “taxes owed” and “taxes paid” in Greece).
But already there are problems with this latest proposed bailout: Britain has announced it will not pay its prorated share of the €86 billion, the IMF has said it won’t pay its share unless there is substantial Greek debt forgiveness, and the Germans continue to bristle at the very notion of a debt haircut. Someone has to blink. In the interim, the EU has made an additional bridge loan of €7 Billion to the Greeks, who, in turn, instantly forwarded the money to the ECB and the IMF to avoid a looming default to each of those parties. Exactly €0 of this bridge loan went to improve the condition of the Greek people or their economy. Greek bank depositors remain subject to a €420 per week withdrawal limit. We are pleased to report, however, that Greek banks have imposed no such limit on deposit amounts, though we have not seen any reports of long lines of Greeks waiting to deposit their savings.
Greek Prime Minister Tsipras continues to press for the passage of the Greek reforms and tax increases while at the same time openly exclaiming how little he supports the very program he is pressing on the legislature. Former Greek Finance Minister Varoufakis has already opined that, "This program is going to fail whoever undertakes its implementation.” Asked how long that would take, he replied: "It has failed already.” When asked how soon the Greeks would be able to sell the €50 billion in state assets, the Greek Deputy Finance Minister replied, “They do not exist.” Note as well that these were the same €50 billion of state assets that the Greeks promised to sell back in 2011. To date the Greek government has sold €2 billion of these assets.
Events in Europe remain unsettled as we write this. Indeed, it would be infinitely more shocking to write that events in Europe are settled. As such, and as we have said repeatedly in the past, we expect Greece to remain a headline issue for several years to come. And, as we have noted on multiple occasions, the current structure of the European Union, with its blurred demarcation of the power to spend and regulate between the EU and its individual member nations will continue to cause economic and political problems across Europe.
We also believe that 100% of Greek debt could be forgiven tomorrow and it would make no difference whatsoever to future Greek economic prospects within the EU and the euro because it is plain after almost 15 years of full participation in the European economy that the Greeks are simply over-matched within the competitive dynamics of the Eurozone. Greece is the only Eurozone member defined as an Emerging Market by MSCI, which looks like an overly optimistic prognosis. Looking back over Greek finances since its independence some 170 years ago, the repeated bouts of debt-induced financial collapse are plain to see and this latest episode will play out no differently.
Meanwhile, 5000 miles away, the Chinese stock market took off like a rocket over the past year. The total market value of Mainland Chinese stocks increased by $6 trillion from June 2014 to May 2015. And then in June, even more quickly, some $3 trillion of that value was gone. As to the causes of this extreme volatility, we think a great deal of the underlying problem is captured in a quote from a Hong Kong housewife back in the 1997/98 Emerging Market sell-off: “I don’t know what to say, I’ve been investing since January and I’ve never seen anything like it.”
Chinese President Xi Jinping signaled he would be a reformer upon becoming China’s leader, and he has not disappointed in that regard. One of the pillars of his plan for economic reform was the decision to allow market forces to play a “decisive role” in allocating resources. Previously, market forces were officially given a “basic” role. The Chinese leadership encouraged citizens to invest in the stock market in an attempt to make its citizenry a source of internal capital formation. Capital formation should lead to job creation, an absolutely vital process as China moves from a rural to an urban society. Some of that encouragement to invest came in the form of looser regulations regarding margin lending over the last 5 years. As a result 25% of the Chinese market is supported through margin financing. Last April, the regulation limiting individuals to one account was changed to allow investors to open up as many as 20 personal accounts and as result there were some 4 million new account openings per week since that rule change.
At the same time, foreign ownership in China’s stock markets remains highly restricted: Mainland Chinese nationals are allowed to buy Shanghai and Shenzhen “A” shares while foreign investors have been almost exclusively limited to owning Hong Kong-listed “H” shares. China has been working to integrate the Hong Kong economy with its own, including the stock markets. This task is not without its difficulties thanks to limited exchangeability of Chinese Renmimbi, the nature of the Hong Kong Dollar, different listing qualifications, laws, regulations, etc.
Mainland China’s “kind of open” approach to markets has resulted in vastly disparate market dynamics between Hong Kong and the Mainland. Most notably, 80% of Mainland trading volume is from retail investors, versus 20% in Hong Kong. These 200 million Mainland Chinese investors can be characterized as more hair-triggered than their foreign counterparts and two-thirds of them have less than a high school education. And the Mainland markets are highly insular: foreigners own less than 2% of all outstanding Mainland “A” shares, whereas foreign investors on any given day can comprise over 60% of daily volume in Hong Kong “H” shares.
With the ingredients for market volatility firmly in place (excessive margin lending combined with inexperienced investors), the June crash in Mainland China stock markets should not come as a surprise. Daily drops in “A” shares of 5% to 10% were not uncommon and by the end of June, the Shanghai index was off by 32% from its June 12 peak. In response, the Chinese Securities Regulatory Agency instituted “timely measures” such as suspending many shares from trading, banning others from being sold at all, reducing margin lending, forcing company insiders to buy shares in their own companies, and having some state-owned enterprises repurchase their own shares. Towards the end of June, some 1400 “A” shares were suspended from any trading and Chinese authorities began a series of police investigations into “malicious short selling.”
It is troubling that the China Securities Finance Corporation (CSF), a branch of the Chinese Securities Regulatory Commission, has become a state-run hedge fund with half a trillion dollars with which to support Chinese stocks. Perhaps there is no better example of the dangers of state-dominated capitalism than the concept of the securities regulator being one of the single largest owners of stocks in the very stock market oversees. In fact, the CSF is now a top ten shareholder in at least 8 publically-listed Chinese corporations and its ownership includes hundreds of Chinese companies. This is the equivalent of combining CALPERS and the SEC.
This episode makes plain that while China has made tremendous economic advances over the past 30 years, and particularly over the past 10, lifting some 500 million Chinese out of poverty in that period and putting China solidly in the #2 economic slot on the world stage, it is not yet ready to assume the mantle of the World’s Leading Economy. Moving China towards an open market economy is the right idea, but it is clear that senior Chinese leadership has little stomach for the short-run stock market volatility of June and July. Whereas Greece may be on the verge of an exit from both the euro and the EU, and possibly might even lose its status as an Emerging Market, we view Chinese prospects for fully-fledged acceptance and integration into the world economy as much brighter. Neither Greece nor China is ready for primetime, but the crucial difference from an investor’s point of view is that one is going through growing pains while the other is struggling for survival.1
Neosho Capital LLC
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