Summary:
EconVue experts comment on the quickly evolving economic situation in China. Is the stock market rout over, and what kind of fallout from the recent plunge can be expected to surface in the "real economy"?
G. Bin Zhao EXPERT
If you have never ridden a roller coaster at a theme park, perhaps because you worry your heart might not take all the excitement, then the thrills and chills of buying Chinese stocks may not be for you. There has been severe turbulence in the Shanghai and Shenzhen markets over the past three to six months, very rare occurrences in the short 25-year history of the Chinese capital market, and international investors are stunned. What has caused this phenomenon, and what should be done to prevent the sudden surges and declines in the future?
First, it is generally known that the recent round of rapid rises in the stock market lacks fundamental economic support. China's macroeconomic growth rate has hit a record low of 7 per cent, and the stock market, after a seven-year bear market that persisted since 2008, started its gradual recovery in the second half of last year, and increased dramatically this year. This phenomenon contradicts the basic principles whereby the stock market acts as a barometer for the economy. So, in the absence of both strong macroeconomic support and profitability among a majority of Chinese companies, the rapid growth of the market in such a very short period planted the seeds for disaster. Of course, the Chinese market is still developing, and historically, its ups and downs have rarely followed any economic laws. This has made it difficult for it to become a channel for investors to share the fruits of growth in recent years.
Second, margin trading and short selling, namely leveraged trading, which started in 2010, boosted uncertainty in the market. During the downturn, it was uncommon for stocks to be bought and sold through leveraged trading, but once the bull market seemed certain, investors gradually increased this trading method. The amount of funds used for leveraged trading through formal and legal channels such as securities and fund companies is estimated at about 2.3 trillion yuan (US$ 371 billion). Obviously, compared with the total floating value of about 40 trillion yuan in the Shanghai and Shenzhen markets, this 2 trillion yuan, which accounted for about 5 per cent of current total tradeable market capitalisation, may have great influence on market swings, but will not quickly change the entire market in the short term.
Third, one of the major reasons, or the core factor, that has resulted in the current turbulence is that a large number of individual investors buy and sell stocks by financing 5 to 10 times the value of their own funds. Since the start of the stock market recovery late last year, many investors, believing the bull market and high returns were just around the corner, borrowed money through different channels to invest. Thus, the entire stock market was transformed into a margin trading mechanism similar to a futures market. For example, investor C has one million yuan for stocks, and he uses this as margin to finance 5 to 10 million yuan from friends, banks or other sources. Their agreement may stipulate that if they make money, they will share the earnings according to certain percentages; but if they start to lose money, the fixed limit is only one million yuan. When the market declines, if investor C is financed at a ratio of 10:1, a 10 per cent drop means he has lost his one million yuan; according to the agreement with his lenders, he must sell all his stocks to stop the loss. Such sell-offs are a major reason for the continuous fall in the market over such a short time. Previous funds invested in the stock market had been relatively limited, but many greedy individual investors, betting that the bull market had finally arrived, borrowed to invest without understanding or fearing the risks. As a result, a lot of money flooded the market, causing it to rise sharply. This financing usually takes the form of individual loans. There is no risk for the lenders, and the loan participants include not only individuals, but also banks and businesses, so the size of the funding can be very large. According to expert estimates, the amount is between 5 trillion and 10 trillion yuan, but because it is hard to get complete information about these loans, it is difficult to determine a more exact total, so the full amount is still debatable.
In short, the Chinese stock market is like a futures market because of massive leveraged trading, and many participants are individuals who lack expertise or training. That is the main reason for this crash. Thankfully, the roller coaster seems to have come to the second half of the ride. Although we cannot predict what will happen next, we must believe in the philosophy of value investing. Bubbles do not often persist, and investigating and resolving the reasons they formed is the key for the long-term development of the market. The regulators who promoted margin trading and short selling intended to boost stocks out of the bear market as soon as possible, but to their great surprise, many individual investors got involved in leveraged transactions through informal channels. The market was a mess within a few months. Institutional investors should be forced to deleverage, and stricter regulations put in place, but the effects of these initiatives may be limited. More large-scale private investment involved in leveraged lending is hard to define and hard to control. One effective measure would be to require banks and other institutions to monitor the use of funds to prevent them flowing into the market. In addition, if applicable, legal means must be considered to combat third-party service providers who arrange financing for individuals. In the interim, when the development of the entire national economy is slowing, overall economic and financial stability is crucial. Sharp changes in the stock market may lead to other risks, which shouldn't be overlooked. Some have criticised the central government for its multiple bailouts, but I believe policy interventions are necessary until mature market mechanisms are formed. Turbulence in the stock market will hit investor confidence in the short term, volatility will probably continue for some time, but the bull market is not over yet; the prelude was just a bit more thrilling than expected. China is suffering a slowdown, but its economy is still thriving compared with others', and so is its stock market.
Comments
China will lead this year’s G20 summit, and in that role Beijing has a unique opportunity to showcase its impressive accomplishments moving the country from an agrarian economy to the world’s manufacturing floor and now to a restructured economy that is service and consumption oriented.
But the early days in China’s capital markets raised significant questions as to whether Beijing can truly realize that opportunity. China’s second capital market rout inside six months, followed by a series of messy currency depreciations and serious bureaucratic bumbling combined to remind investors that China’s economic ship may be turning but perhaps not fast or far enough.
There is deep concern about the course and provision for reforms. Simply put, the current course appears to give short shrift to the necessary capital and financial market reforms that are so needed to free up this economy and establish sustainable, competitive and credible markets.
While Beijing’s successful lobbying of the IMF to add the RMB to the ranks of the world’s lead currencies offered a glimmer of hope, true progress will only be marked by the injection of market transparency, the institutions that are needed to support that transparency and important albeit difficult steps to reduce government’s role as primary stakeholder.
The state of the global economy won’t make things any easier for Beijing. By the same token, things won’t be easy for investors who remain bullish long-term even as they hold their breath during these intermediate spurts of high drama.
In a recent article, Henry Paulson, former US treasury secretary and former chairman of Goldman Sachs, appealed for the Chinese government to accelerate financial reform after the stock market turmoil. The president of the World Bank, Jim Yong Kim, also said that although many people worry that the market bailout would delay the necessary changes, he believes China will remain committed to reforming the financial sector.
Clearly, the recent volatility in the stock market and the rapid response by the central government touched the nerves of foreign investors and sparked a lot of criticism. International investors have reduced their holdings in Chinese stocks by 44.2 billion yuan (HK$55.1 billion) through the Shanghai-Hong Kong Stock Connect since July 6. The chief executive of BlackRock said the bailout has damaged the country's reputation and could lead international investors away from the Chinese market. Some believe the bailout will affect progress for Shanghai and Shenzhen stocks to be included in the MSCI World index.
The reason for these harsh words and the swift response from overseas investors is that there is a belief that the bailout has disrupted the familiar rules of the game. Seeing that their share of the market suffered a loss, they chose retreat as the best strategy. It is worth noting that some Japanese investors have been aggressively buying Chinese stocks since the recent crash, believing that China's economic growth presents many investment opportunities despite the stock market's ups and downs.
I believe in the theory of the market economy and staunchly support China's reform and opening-up policy. I occasionally criticise the fact that reforms are not thorough enough, but I fully endorse the series of relief measures taken by the government in this situation. Furthermore, I still believe that if the US government had taken measures in 2008 to save Lehman Brothers, the global economy might have not fallen into such a long depression.
It has been difficult to determine the type of intervention governments should adopt during a financial or economic crisis. Moreover, compared with the London and New York stock exchanges, which have histories of more than 200 years, the Chinese market is just a faltering toddler. It is clearly inappropriate to judge it by applying the standards of the developed markets.
It can be said that the stock market turmoil is one of the most serious economic challenges since Xi Jinping and Li Keqiang took power. Financial risks resulting from this turbulence may have a serious impact on the economy, and may also lead to turmoil on a wider scale. When the relatively fragile overall economy in the so-called new normal period faces a major challenge, all high risks deserve special attention.
From mid-June to early July, the index fluctuated within a range of 1,659 points (the highest was 5,166 and the lowest 3,507). The decline of more than 30 per cent wiped out capitalisation of about 20 trillion yuan, equal to 31 per cent of China's gross domestic product last year (63.65 trillion yuan).
A decline of such a large scale may have led to a wider crisis had the government not acted immediately. If the decline had continued, it may have triggered not only an economic crisis, but also possibly a political event threatening social stability.
Therefore, it is unfair to criticise the government bailout. From the perspective of trying to prevent a wider financial crisis, the measures - which included establishing a stabilisation fund to purchase shares and calling on state-owned enterprises to take on buyback shares - have increased investors' confidence, preventing a continuation of the frenzied sell-off and ensuring that the market did not collapse.
Many people worry that the powerful measures the central government took will affect the progress of financial reform. Professor Li Daokui estimates that the stock market crash will have a limited impact on consumption and the real economy. Although the first five months of this year had a large number of initial public offerings, the amount of total financing for these new stocks accounted for only 4 per cent of total financing for all stocks, bonds and bank loans.
I believe, since there is no widespread erosion of the real economy, China will not review the plans for financial reform proposed at the end of 2013 during the third plenary session of the 18th Central Committee of the Communist Party. However, we need to conduct a comprehensive review of the planned stock market reforms to determine exactly the type of capital market we should establish.
For example, Paulson suggested that China allow market participants - including the top international institutional investors, investment banks and brokers - to compete equally in the Chinese capital market. This viewpoint is particularly questionable. At a time when the domestic counterparts are far from competitive with foreign market participants, further opening of the capital market needs to be carefully researched and designed, and done with extreme caution.
Finally, less than two years after the third plenary session, general financial reforms have made great advancements of a type rarely seen in the past few decades. I believe the dark clouds over the stock market will gradually subside, the sky will be even brighter after the storm, and the winds of reform will continue to blow across the Chinese economy.