On Wednesday, as global markets teetered following a strikingly deep selloff on China’s Shanghai Composite index, Morgan Stanley Investment Management emerging markets expert Ruchir Sharma related a disconcerting anecdote about the nature of the Sinosphere’s unalloyed self-assuredness. The downward correction that hit Chinese markets should have been predicted weeks earlier when officials who had expected a June 15 stock market rally timed to coincide with the People’s Republic President Xi Jinping’s birthday were shocked when the day instead yielded a 2 point market contraction. Sharma suggested that such a fanciful notion that a Chinese leader’s birthday should result in bullishness was an outgrowth Chinese officials’ belief in the government’s omnipotence, particularly in regards to matters financial. But the latest selloff is chipping away at the image of Zhongnanhai’s infallibility. The Communist Party’s rule in Beijing may be threatened by a substantial depression of its irrationally inflated markets, and they know it. What’s more, the PRC will do all that is within its power in order to maintain its preeminence. 

“There are four basic signs of a bubble: prices disconnected from underlying economic fundamentals, high levels of debt for stock purchases, overtrading by retail investors, and exorbitant valuations,” Sharma observed in his fascinating piece in the Wall Street Journal sizing up the scope of the disaster that could be about to unfold. “The Chinese stock market is at the extreme end on all four metrics, which is rare.”

In Beijing, authorities have adopted increasingly feeble and apparently desperate efforts to prop up the ailing markets. Overnight, the PRC increase the total number of stocks that it had halted the trading to 745 – a full 26 percent of the firms trading on mainland Chinese exchanges representing $1.4 trillion in shares, or 21 percent of China’s market capitalization. “The central bank is shoveling cash towards a state-backed finance company that lends to individuals who would like to make bigger bets on the stock market than they can afford,” the Guardian’s Nils Pratley marveled. The state has, in essence, begun to subsidize ill-advised speculation in order to continue to prop up the value of already wildly overvalued stocks. The government has also taken to buying up large, state-owned firms in an effort to shore up the market but will have the effect of further distorting it.

Why are Beijing’s authorities embracing such shortsighted measures? “One assumes they think a serious slide in share prices would cause financial distress among 90 million individuals with share accounts,” Pratley observed. “That might damage the real economy or, conceivably, create social unrest.” Precisely.

The PRC remains haunted by the ghosts of Tiananmen Square and an earlier generation of PRC leaders who deftly embraced of just enough aspects of Western capitalism to stave off a regime-toppling revolution in the wake dissolution of the Soviet empire. Beijing understands that its regime maintains the confidence of the governed only as long as it can continue to deliver prosperity to its stakeholders in coastal urban centers. Last week, the regime codified this innately understood principle into law when it adopted a new statute that directs Beijing to regard “financial risk” as an existential threat to Chinese security equal to conventional national security threats. “The law explicitly states that economic security is the foundation of national security,” the Journal’s Andrew Browne reported.

“Social stability has become the overriding concern of the bureaucracy. Indeed, the most critical job-performance target for local officials is to prevent social unrest from breaking out on their patches,” he continued. “If the Shanghai index continues to sell off despite the all-out government attempt to change its course, the damage to the party’s image could get worse. Ironically, in his quest for absolute security for the party, Mr. Xi may have just undermined it.”

A familiar story as old as time itself is starting to play out in China. As the prospect of domestic turmoil looms, the increasingly irredentist government has taken to whipping up xenophobia. Rumors are apparently circulating that foreign investors are intentionally shorting stocks, leading to the market crash. If the turmoil continues, the PRC’s ongoing disputes with a variety of Asia-Pacific nations and the United States in the South China Sea makes for a perfect outlet for the public’s outrage. It wouldn’t be the first time.

In the West, however, the fear that the contagion in China could spread or have substantial political fallout inside the PRC has been relatively muted. In virtually the same way that the Greek referendum, which might lead to the truncating of the Eurozone for the first time in its history, did not spark much concern in Western financial sectors, so, too, has China’s trouble’s been dismissed. These distant affairs, they say, are contained.

In the United States, a steady improvement in the unemployment rate masks the softness of the labor participation rate. “Purchasing managers are reporting the slowest rate of manufacturing expansion for over a year-and-a-half, suggesting that the economy is slowing again,” Markit Chief Economist Chris Williamson warned last week. An interest rate hike from the Federal Reserve that was expected this summer may not be forthcoming until later in the year. “The IMF, which cut its growth forecast for the U.S. last month, said the Fed could be forced to reverse course next year if the central bank proves overly optimistic about the health of the American economy,” the Journal revealed. While the Dow Jones Industrial Average has largely shrugged off these crises overseas, this confluence of events is a troubling place to be heading ominously into the autumn.

“Most crashes tend to be in the fall,” COMMENTARY contributor John Steele Gordon once remarked of the great crash in October 1929. “I think it’s human psychology, you tend to be more cautious in the fall. The speculations of summer that seem so brilliant, suddenly, when the chill winds of October come, you wonder if they’re such a good idea and you try to get out.”

Both China and Greece have taken the wrong lessons from their financial crises. They have tried to remedy disasters brought about by their rejection of economic physics in favor of comfortable and unsustainable fiction with more of the same. Perhaps these crises resolve themselves and remain “contained,” but the storm clouds that have been gathering over the course of 2015 should not be dismissed.


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