Global Deflationary Wave Round 2 or Why Did China's Government Create a Equity Bull Rally?

Why is the Government's intention to start the stock market it? The main reason is difficult to reverse the economic cycle, monetary policy transmission mechanism failed, prompted the government to adopt unconventional means to change market expectations.

—Liu Shan, deputy editor of the China Business Times, explaining why China's government spurred a bull market rally.

He notes how powerful the rally has been over the past few days: volume exceeded ￥1 trillion on Friday, 2.5 times the volume at the peak of the market in 2007, when the index was more than double current levels. Money supply has grown 300% in the past seven years.

The main reason why China "needs" a bull market in stocks is the same reason the central banks are buying S&P 500 futures. The modern global financial system is a credit based system, not a fiat currency system. Banks (and shadow banks) create most of the money in an economy; in the case of the United States, outstanding credit is about 60 times the amount of currency and 5 times the amount of M2 money supply. At the peak of a credit cycle, the money creation mechanism breaks down. In the developed economies, the crisis is huge because the credit cycle in question is measured in generations. It is not a business cycle measured in years, but a major credit cycle measured in decades or even generations, with major, immovable factors such as demographics playing a crucial role.

In China, demographics are also playing a role. As this article discusses 房市2015年危险信号：购房适龄人口达峰值, China's home buying population is reaching its demographic peak. There are those who argue that Chinese will still buy new homes and trade up, but the demographic dividend will peak in 2015. As in the United States, and Japan and Europe, the labor force has peaked as the country begins to age. In China, the working age population will peak at 568 million and in 2018 will begin an accelerating slide, reaching 500 million in 2025. The population of urban home buyers was 328 million in 2012, is expected to peak at 335 million peak in 2016 and then decline thereafter, sliding to 314 million in 2020 and 250 million in 2030. Analysts see a limit to the number of migrant workers moving to the cities, with one analyst seeing growth of only 10 million migrants a year after 2017. Marriage grew at 10% from 2005 to 2009, but this growth slowed to 4.4% by 2012 and will slow even faster as demographics turn negative. I noted this back in 2011, when China's entry level workforce started to decline. This was discussed in the context of real estate here: Low Fertility, Low Household Formation and High Real Estate Prices.

In China, as in the United States, mortgage and real estate finance forms the base of the financial system. If peak real estate is reached, then peak debt demand is reached, and peak money creation is reached. Slower credit creation leads to slower economic growth, which isn't a major issue for countries with low debt levels. For those up to their eyeballs in debt, such as China, Japan, the US and EU, a slowdown in credit growth threatens the financial system because growth is not enough to repay existing debts, let alone finance the new debt that is needed to create faster rates of growth/inflation (either real growth or nominal growth via inflation will satisfy the financial system).

In a world where the credit creation mechanism is broken, inflation is nearly impossible. There must be a lender and a borrower in order to create credit, but if even one party is impaired, credit growth will evaporate. The only way central banks have been able to generate inflation has been via asset purchases and central government borrowing. The central banks are monetizing the debt by taking it onto their balance sheets. If the economy doesn't grow, all they will achieve is the collapse of the central bank and a sovereign debt crisis. China is in a better position than developed economies and probably could create inflation if it let the credit system run wild, but China doesn't want the crisis that would follow. China will try everything before it resorts to inflation, and one of the last ways to boost growth is for a bull market in stocks to ignite risk taking, equity finance and wealth creation.