Global Market Brief: China's Engineered Drop (George Friedman)

  With Tuesday's market correction being the single biggest decline in the U.S. markets since 9/11, all eyes are focused on figuring out what exactly happened as well as what is going to happen next. Stratfor President George Friedman explains what took place in China and how this was an "engineered drop."

  By George Friedman -- John Maudlin's "Outside The Box"

  Mar. 1, 2007 -- China's Shanghai Composite Index tumbled 8.84 percent Feb. 27, its largest fall in a decade. Its sister index, the Shenzhen Composite Index, fell 8.54 percent. The size of the drop in China is not significant in and of itself. On a number of occasions during the past year, the Shanghai Stock Exchange has experienced 5 percent-plus daily reductions, and it has already boomed and busted once this decade. But that hardly means the development is insignificant. The fall is important both for how it happened and what it triggered.

  How it Happened

  This was an engineered drop.

  The Chinese government has become increasingly concerned about levels of investment in its economy or, more accurately, the sheer amount of money that is chasing projects. State firms with limitless access to subsidized capital from state banks have used that access to launch thousands of nonprofitable firms. This glut in "investment" money drives up the cost of commodities and adds industrial capacity without actually producing anything of much use, making life more difficult for the average Chinese and unduly harming relations with foreign powers that face a glut of otherwise noncompetitive Chinese goods.

  This penchant for overinvestment has now spread to the stock market in two ways. First, the same politically connected government officials who started dud companies are taking out loans to buy shares, or are using shares they already hold as collateral for new loans. Second, ordinary Chinese citizens have started borrowing -- sometimes against their homes -- in order to play the market. In January, the number of total traders on the Chinese exchanges grew by 1.38 million, an increase of 134 percent from a month earlier, while stock turnover was up 700 percent from a year earlier.

  The net result is an absurd stock surge with no basis in fundamentals. At present, some Chinese banks now have price-to-earnings ratios higher than financial behemoths such as Deutsche Bank and Chase, despite deplorable management and a history of highly questionable lending policies.

  For the past few months, the government has been working to drive down this speculative investing. On Feb. 26, China's State Council launched a new "special task force" that accurately could be referred to as the "get- those- idiots- to- stop- borrowing- to- gamble- on- the- stock- exchanges" team. Its express goal is to get the Chinese domestic security brokers to lay off such speculative decision-making, while also putting a crimp in the source of the subsidized capital.

  Day one started by the script, and Beijing is likely quite pleased with the way things are going (or at least it was until its actions unintentionally triggered a global meltdown). Also, since the Shanghai exchange is actually still up 3 percent for the past week despite suffering its largest drop in a decade, the State Council probably hopes for more drops in the days ahead.

  What it Triggered

  But the rest of the world took a different lesson. Why the Chinese stock crash occurred was unimportant to the outside world, only that it did -- and that it affected everyone else.

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