I guess watching Shanghai can’t be any worse for your financial health than paying attention to  CNBC.  It also sounds cool to be talking about exotic markets.

On the other hand, I don’t think the commentators who have been citing Shanghai weakness as the cause for similar drops in US and European stock markets understand how limited an indicator the Chinese index is.

Although Shanghai is no longer the nursing home for inefficient state-owned enterprises that it used to be, real investment clunkers still abound.  But there’s no bond market to speak of.  With minor exceptions, the Chinese government does not permit its citizens to invest in securities markets abroad, just as it doesn’t allow foreigners to invest in its domestic markets.   So one reason for corporations and individuals in China is that, other than bank deposits, there’s no other place to invest your money.

Another thing to understand is that, despite the infusion of Western knowhow over the past decade or so, Chinese banks are still not independent financial institutions of the type we’re used to here.   Instead, they are arms of the state, run by high-level government employees who are also members of the Communist Party, and who get promoted (an over simplification, but basically true) by doing what the central government tells them.

So when, in the depths of the economic contraction late last year, Beijing devised a stimulus plan and ordered the banks to step up their lending, the banks complied (unlike here in the US)–and lent a lot.

Almost a month ago, China announced that the banks had achieved 75% of their full-year lending quota in the first half.  Beijing also privately told the banks  to take their feet off the accelerator.  Of course, again they complied.

It turns out–no surprise here–that a big chunk of the increased lending was very short term finance that the borrowers used for stock and commodities market speculation.  So the order to slow down lending growth was a signal that unofficial margin lending requirements were about to be tightened up.  This signal was confirmed as short term arrangements matured and were not renewed, creating in effect a gigantic margin call.  Hence the sharp drop in the Shanghai index over the past three weeks.

I think you can make a case that the withdrawal of financing for commodities speculation in China could be a cause for some softness in the price of industrial raw materials.  But the fall in the Chinese stock market is not a harbinger of upcoming problems for the Chinese economy.  On the contrary, the withdrawal of extraordinary stimulus is a signal that China thinks its domestic economy is back to normal.

Margin-related stock market movements usually take several weeks to play out.  If what I’ve said above is correct, and absent any further tightening moves by Beijing, we should see Shanghai settling down in short order.