Moral Hazard and China By: Gabriel PotterMBA, AIFA® 2015.07.20

Moral Hazard, n. – lack of incentive to guard against risk where one is protected from its consequences. 

We've spent the past few blog posts talking about Greece.  Now that the Eurozone seems to have relatively settled, let’s focus our attention on the other big story of the quarter:  China’s slowdown.  The official party line from President Xi Jinping is still calling for a robust GDP growth rate of 7% - a rate far in excess of developed world counterparts.  The problem, essentially, comes from the source and stability of this imputed growth.  Roughly speaking, you can attribute growth from two directions:  private sector organic growth or public sector action. 

The Chinese have been told for decades that they need to liberalize their economic system and they’ve certainly made progress.  However, the unintended consequences of government policy and actions always exist to derail the faltering progress they’ve seen.  For example, limited investment options for Chinese citizens piled money into one of the few options available:  domestic real estate.  Economists could see the bubble forming, and the potential for collapse, but China’s government is flush with cash, and ready to apply stimulus dollars to prevent a political headache from an unacceptable price correction. 

More recently, this pattern repeated itself (in an accelerated fashion) with the Shanghai stock exchange.  Notably, the Shanghai stock market index is driven almost exclusively by local (Chinese) investors and is lauded by the ruling party as an advance into the world of sophisticated market reform and organic progress China needs.  Sometime in 2014, the Shanghai stock market started to boom upwards as the captive domestic audience started piling in a classic speculative fashion.  In other words, individual Chinese investors – up to 90 million – noticed the burst in stock prices and, jumped in on action.  This is fine during the boom cycle, when their indices jumped more than 100% within a year, and the political elite could point to the incredible returns as demonstrable proof of China’s continued ascendance.   Many western economists noted that the fundamentals could not possibly justify the ludicrously expensive prices of the Chinese stock market.  The inevitable market correction – the boom-and-bust cycle – started in 2015.  The problem now is that the Chinese government, unable to politically tolerate such weakness, has spent tremendous sums buying assets to shore up prices and halt the correction.  The Chinese government action does two things:  first, it demonstrates the relative weakness of government action vs. market forces.  Second, it makes an explicit moral hazard problem as investors are made to believe that the Government will halt downward corrections in the stock market, no matter how warranted.  This can only end badly. 

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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