China's Game of Jenga

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The game of Jenga

Most of you would be familiar with the game. For the uninitiatied, the game involves players taking turns to remove blocks from a tower constructed of 54 blocks and balancing each piece at the top of the tower, creating a progressively taller but less stable structure. Everyone seems to enjoy the game – including Chinese policymakers and central bankers from the People’s Bank Of China (PBOC).

The Chinese economy resembles a giant game of Jenga, with the tower being the Chinese economy and the blocks being cheap debt, courtesy of PBOC’s loose monetary policy. And like all games of Jenga, the game will eventually come to an end when the tower comes crashing down. Except, there will be no winners and players do not have the privilege of starting from a clean sheet. China’s game of Jenga may soon come to an end.

Dream turned nightmare

The “Chinese Dream”, first adopted by Chinese President Xi Jinping in 2013 as the new party slogan, was about the great rejuvenation of the Chinese nation. Although the market is still up by 75% over the past year, despite meeting a violent end last month, the plunge in China’s stockmarket was enough to turn many Chinese dreams into nightmares. The plunge had wiped out more than $3.5 trillion worth of wealth, which culminated in the suspension of trading for more than half the listed companies and other forms of government interventions, such as the restriction on short-selling.

With ChiNext reaching a staggering price-to-earnings multiple of 147 at its height in early June, knowledgeable investors would have seen it as one of the many warning signs to steer clear of the rout. Unfortunately, with mom-and-pop investors making up 80% of China’s 42 trillion yuan stock market, many had no idea that their gravy train was leaving the station.

While bullish investors of China may seek solace in the fact that total market capitalization of China’s stockmarket is less than half of its GDP, compared with more than 100% in most rich countries, the recent wipeout worth more than 10 times the size of the Greek economy undoubtedly raised doubts regarding the future of China’s economy. Exactly to what degree does price flucuations in the Chinese stockmarket reflect what is truly happening in the real economy? How widespread will the impact be if the Chinese stockmarket does crash?

The price of misprice

The question, “how much”, is probably the most important underlying concept behind Benjamin Graham’s “margin of safety”. The term “price” does not get enough credit for its vital role in an economy. While demand and supply may not be directly observable, prices are crucial and valuable information that allows us to make decisions and to understand the economy as a whole. Chinese shares’ price appreciation was never justified in the first place amidst a weakening economic outlook. Now, as China engages in a slew of seemingly frantic and futile attempts to stabilize the market, price information in the Chinese Stock market may no longer, if it ever was, reflective of China’s real economy. The implications of the Chinese government intervention and lack of price transparency can be terrifying. Aside from obvious implications, such as the erosion of credibility and heightened uncertainty, such measures fuel moral hazard and adverse selection.

Such actions have deep-seated impact on the economy in the long run. Not only are resources allocated inefficiently, by allowing roughly half the listed companies to suspend trading and placing restrictions on short selling, the Chinese government has effectively prevented market forces from correcting themselves and also protected inefficient companies from failing. In addition, by promoting a “state bull market”, the government encouraged moral hazard in which neither investors nor companies face consequences of bad decisions, knowing that the state will come to their rescue. The runups to the Asian Financial Crisis and the recent Great Recession have taught us that such mindsets are recipes for disaster.


The massive build up of China’s debt is worrying to say the least. The use of leverage, which helped propel the initial stock rally, is now compounding its downturn. The worse part – nobody knows how leveraged the Chinese economy truly is. Although margin financing is estimated to be about 2.3 trillion Yuan, actual leverage in the economy is likely to be much higher with China’s shadow banks and peer-to-peer lenders.

Within the past 9 months, the PBOC has delivered 4 rate cuts, 3 reserve ratio requirement (RRR) reductions and abolished limits on the amount of deposits banks can lend. Fashioned after the Greenspan Put, the “Beijing Put” has resulted in China’s debt growing faster than its GDP. Since 2008, China’s private sector debt has doubled to 207% of GDP while nonperforming loans have already climbed by a record 140 billion Yuan. As the trend continues, a series of default in China, the world’s largest corporate borrower, may trigger a full-blown debt crisis on the international markets.

While it has been argued that the fallout of any potential debt crisis could be limited given the Chinese government’s effective ownership of Chinese banks, the ballooning debt level may eventually become unsustainable even for the deep-pocketed PBOC.

Running out of growth drivers

With China’s capital expenditures stagnating, signaling a slowdown in investment on infrastructure, the economy is increasingly dependent on Chinese consumers as sales and retails showed improvements over the past quarter.

However, as the stock rout showed no signs of relenting, we can expect further losses in consumer wealth. As investors liquidate assets to cover their losses in their leveraged positions, we can expect downward pressure on the real estate property market, which has also been instrumental in the rise of the Chinese economy. As most Chinese wealth is being invested in the property asset market, the contraction in the property markets also post a risk to the ailing Chinese economy.

Despite slipping less than analysts had expected, Chinese exports remains weak with no signs of clear rebound. As the Chinese exporters struggles amidst declining export competitiveness and the effect of a stronger Yuan, sluggish demand in the United States and Europe places further pressure on Chinese exports.

All of the above mentioned points towards a grim future for the Chinese economy. As the Chinese government grapples with the need to find new growth drivers and new avenues for investment, money is leaving the country to safer alternatives.

Made in China

Given the rapid growth in debt, the opague nature of its markets and government, rising debt-to-GDP, moral hazard created by state support, and the lack of growth drivers to sustain the economy, the only pillar of support of China’s vast economy seems to be the confidence placed in the Chinese government’s willingness and ability to act as a backstop. Sadly, confidence alone is not going to stop the Chinese Jenga tower from eventually collapsing.

Till China learns that investors’ confidence and the markets are beyond the Communist Party’s control, the Chinese dream will always remain as a dream. And, we may yet observe another characteristic Jenga and the next financial crisis have in common – that is they are both “made in China”. Now that is an export no country will wish to have.