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Moral hazard and China

Daryl Guppy
Daryl Guppy10/14/2021 04:48 PM GMT+08  • 6 min read
Moral hazard and China
China is supposed to be replete with moral hazard which ensures that the omnipotent State will bail out Evergrande.
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For some people, a moral hazard is going to Geylang at 1.30 in the morning to eat frog porridge.

But in this case, moral hazard is about taking risks because you believe you are protected from the consequences of failure.

China is supposed to be replete with moral hazard which ensures that the omnipotent State will bail out China’s Evergrande property group.

It may be a comforting belief, but it is misplaced and that has significant consequences for investors.

In considering the Evergrande situation, we need to start with the US. It seems an unlikely starting point, but the US is the home of moral hazard.

No, it does not start with the bailout of “too big to fail” banks in the 2008 Global Financial Crisis. Nor does it start with the Federal Reserve coordinated bailout of Long-Term Capital Management in 1994.

In modern times, it starts with the bailout of thousands of investors who were victims of the savings and loans crisis, or the failure of 1,043 out of the 3,234 savings and loan associations in the US from 1986 to 1995.

That bailout cost a cool US$160 billion in 1990.

There are two features to note here. First, none of these bailouts signalled the end of the economic and financial system as we know it. A bailout of Evergrande would also not signal the end of the financial system.

Secondly, the implementation of a moral hazard environment in financial markets is widely practised. So, if this action was taken by China, it would not be unusual.

But does this signal a high probability of a government bailout of Evergrande? Probably not, although it would be a response consistent with those taken by the US in similar situations.

There is the apparently unthinkable notion — the total collapse of Evergrande. However, it is really not that unthinkable.

This consensus conveniently ignores the resolution of the peer-topeer (P2P) collapse in China. P2P lending is a valuable service concept that enables the un-banked to access credit capital.

Under a light-handed regulatory regime, the P2P lending services ballooned and mutated beyond their original purpose and became an instrument of mass financial destruction.

The process of restoring order was very painful. Hundreds of P2P lenders simply fled or defaulted when the regulation crackdown commenced. No individual P2P lender inflicted a billion-dollar loss, but collectively it is estimated that US$115 billion ($155 billion) was lost to investors.

The P2P situation is similar in many ways to the US savings and loans crisis, but China’s response was directly opposite to that adopted in the US.

China is not protected by a blanket of moral hazard. Painful collapses are allowed to take place even though it inflicts pain on many investors.

It is probable that Evergrande will end up as a managed collapse, just as the Federal Reserve did with LongTerm Capital Management.

No matter what the outcome, it is most likely to destroy the myth that China’s business activity takes place under the cover of moral hazard.

This is because the State will always step in, and that pulls the rug out from under some assumptions about investing in China.

Technical outlook for the Shanghai market

The Shanghai Index fell below the important 3,580 support level and then rebounded unsuccessfully. This level acted as a resistance feature for much of this year.

After the September breakout above this level, it was anticipated that the 3,580 level would then act as a support level.

This did not happen. Instead, the market twice fell strongly below this level. The next strong historical support level is near 3,450.

This retreat represents a return to the trading behaviour which dominated the market in 2021. During this period, the index oscillated around a central support and resistance level at 3,450.

The dominant feature of the Index chart is again the long-term support and resistance level near 3,450.

The market has swung, or oscillated around this level on a consistent basis for 2021.

The upper point of the oscillation is the resistance level near 3,580. The lower limits of the oscillation are near 3,330.

The index spent the first five months of the year largely confined to the lower half of this oscillation band. There was a general upwards trend defined by trend line A, and this led to the market breaking into the upper half of the oscillation band in late May.

The index enjoyed a bullish few months until the collapse below trend line A and the central support level near 3,450. The trend line then acted as a resistance level until the most recent breakout developed in September.

When the index retreated, it briefly hovered around the value of trend line A before developing the current move below 3,580.

In the future, the long-term trend line A will also act as a resistance feature, limiting future breakouts. This quickly capped the rally on Oct 8.

However, in the short-term the market will possibly move towards the central line of this broad trading band near 3,450.

As the market retreated from 3,720, there were five potential support features.

The first is the value of the shortterm uptrend line. This was a rally trend line and the index moved below this line confirmed that the rally has ended.

The second and more important support feature is the value of the lower edge of the short-term group of averages in the Guppy Multiple Moving Average (GMMA) indicator.

This also failed as a support level. The short-term GMMA is now testing the lower edge of the long-term GMMA.

The third support feature was the value of the long-term uptrend line A. This also failed as a support feature.

The fourth support feature was the horizontal resistance line near 3,580. This also failed as a support feature.

The fifth feature was the value of the lower edge of the long-term GMMA group of averages. This also failed.

These five support failures confirm strong downside selling pressure and a move towards the centre of the trading band near 3,450.

Daryl Guppy is an international financial technical analysis expert and special consultant to Axicorp. He has provided weekly Shanghai Index analysis for mainland Chinese media for two decades. Guppy appears regularly on CNBC Asia and is known as “The Chart Man”. He is a national board member of the Australia China Business Council. The writer owns China stock and index ETFs

Photo: Bloomberg

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