Chinese Equity Bubble

The Chinese Equity Bubble is Popping

The Chinese equity rally began in earnest in late November 2014, climbing 7.25% in one week alone. Fast forward to Monday 15 June 2015 and the euphoria had all but evaporated. From 12 to 19 June the Shanghai stock exchange dropped 13.32% and it continues to come crashing down, having lost 32.11% from its peak in just under a month. A similar story is playing out on the Shenzhen stock exchange, which has lost 40%. You would be forgiven for thinking that the title of this article is the name of a Chinese factory middle manager, but it in fact reflects the sentiment of many Chinese shareholders.

The stock market rise was not prompted by stellar economic fundamentals. China’s growth has been slowing down for at least a year now from the heady double digit growth seen in the previous decade. The government has officially set the growth target at the “new normal” of 7%; but with global demand slowing and Chinese factory production paring back, even this looks difficult to maintain.

The cause of the meteoric rise in the stock market was really the huge increase in trading accounts for retail investors; in May alone, 12 million trading accounts were created. The stock market mania was almost limitless – according to the Wall Street Journal, 97% of the increase in Chinese manufacturer profits in April of this year came from “Securities Investment Income”. Chinese manufacturers were paring down production and investing in the stock market to earn profits!

 

Chinese Equity Bubble

Figure 1 - Source: Bloomberg

In addition, the State had been publishing articles in the state media justifying the valuations seen on the stock market and the cutting of interest rates pushed investors to get off their pile of cash and put it in equities, often on margin.

Credit Suisse claims the rally was entirely fed by domestic investors and leverage, funnelling money from their bank savings and real estate investments. The rapid pile-in from investors pushed prices far away from sensible valuations and the lack of sophistication in the investor pool meant that the ensuing panic spread quickly.

“Jinping” the Gun

The Chinese government’s response to the crash has been to intervene as much as possible to try and stem the tide:

  • The Central Bank has provided liquidity to China Securities Finance (CSF), a state entity that provides margin financing to brokers. The liquidity is being provided to “hold the line against the outbreak of systemic or regional financial risk”. In other words, CSF is purchasing shares directly.
  • 28 companies have “voluntarily” suspended their IPOs.
  • Fund managers have pledged to help stabilise the market by purchasing units in their own funds and holding onto shares for at least a year.
  • A market stabilisation fund has been established, with 21 of China’s largest brokerages contributing RMB120bn. The brokerages contributing to the fund will not sell stocks as long as the Shanghai Composite Index remains below 4500.
  • The China Securities Regulation Commission relaxed margin lending rules and cut trading fees.
  • Trading has been halted in 1476 stocks; over 50% of the listed companies on the Shanghai and Shenzhen exchanges.
  • Government-owned companies have been instructed to not sell their shares.
  • “Qualified insurers” have been cleared to increase their asset allocation to equities.
  • Margin requirements have been raised for shorting contracts on the small-cap CSI 500 Index.

The effectiveness of these measures will be interesting to monitor – from our perspective it is like pouring water in a sieve, but the Chinese people have immense trust in their hitherto omnipotent government.

Economic Impact

The million dollar question is what impact this equity disaster has on the real, day-to-day economy of China. There are a number of channels through which the drop can be felt:

  1. Household Wealth: Consumers taking losses in stocks have reduced wealth. This effect is muted however, as stocks only represent about 15% of households’ financial assets. A much more concerning impact on consumer wealth is the languishing property market, as the average Chinese household has 75% of wealth directly invested in real estate. Furthermore, an idea of the scale of the investor market is appropriate. At the end of May, brokerage accounts numbered 175 million. During April, the “one investor, one account” rule was removed, meaning that 175 million overstates the number of actual investors exposed. The China Securities Depository and Clearing Corporation lists 90 million investors in mid-June. Considering that only 55% of these accounts actually had any securities, you’re looking at an exposure of 4.3% of the Chinese adult population.
  2. Company Profits: As mentioned earlier, companies have been speculating in the stock market to increase revenues. State-owned companies have been forced to hold on to their shares; so it looks like unrealised losses will be sustained and impact profitability. Market commentators have claimed that the forthcoming drop in brokerage revenues from this crash will significantly impact GDP. However, a report by Scotiabank sees this view as exaggerated, as the official data is aggregated. Hence it is difficult to really attribute financial sector growth to brokerage fees. In addition, before the stock market rally, financial sector growth was already strong. The rally only added about 6% to financial sector growth, which amounts to a grand total of approximately 0.3% of GDP growth. Not terribly significant, but still worth consideration.
  3. Investment: Fewer IPOs impacts the growth in private sector investment, directly affecting GDP. Indeed, the suspension of 28 IPOs is concerning for the pace of investment in the country. However with new equity issuance only accounting for 5% of aggregate financing in the economy, the effects are minimal at worst.
  4. Consumer Confidence: The erasing of wealth that is taking place, even if it is a minor proportion, damages consumer confidence. Automotive demand is already softening as consumers hold out on purchases of new cars. This is an important channel because a key aspect of the Chinese government’s policy is switching China from an investment-led economy to a more Western-style consumer demand driven one.

Furthermore, the Financial Times reported on the commodity market being impacted by the crash in equities. In order to meet margin calls on losses, investors have been selling copper. Copper is commonly used as collateral for margin lending. As a result, copper has reached its lowest level since the 2008 financial crisis. This may have positive effects in the short term for Chinese industry, as copper is a key commodity.

The effect on the banking industry is another source of concern for many, as a lot of the gains have come about on margin. Fitch reported that the exposure to margin lending by large banks looks to be small, however The Economist puts the figure at 1.5% of the total assets in the banking system.

In conclusion, the risk posed by a stock market crash on the real economy is through the consumer confidence channel, and the knock-on effects of equity losses. However, the impact on consumer confidence is only in the very long-term as China shifts to a consumer-driven economy. A primary concern is a strong drop in the property market, should Chinese investors need to liquidate their properties to meet margin requirements. In that case, a small percentage of investors could make a huge difference to the market, and in turn, everyone else (75% of the average Chinese household’s wealth is in real estate). Depending on the outcome of the government’s attempts to stem the outflow, this could develop into a big problem. The encouragement of pension fund investment into equity is also a concerning development; if the government’s bet doesn’t pay off, then there is a much more significant channel through which the stock market will affect the real economy systemically.

“Peking” Around the Corner

The crashing of the Chinese equity market has come at an interesting time for world developments. The S&P 500 is clearly overvalued, Fed interest rate hike speculation is punishing bond markets and the dollar is soaring. Add to this the fears floating around “Grexit” and you have a perfect storm of market anxiety.

Could the Chinese equity crash set off a chain reaction world-wide? It certainly wouldn’t hugely impact any financial market due to its self-imposed segregation from foreign markets. There is some linkage however, and market fear is an irrational animal. For instance, there is currently a general sell-off in commodities and emerging markets and this is expected as China is itself an emerging market and hence is lumped in with other investments. It is a sentiment issue.

There are bright spots in the doom and gloom however. The Renminbi peg effectively removes currency risk in any Chinese investment and the dramatic rerating taking place may yet present good value. After all, the Chinese economy is not crawling… it’s still growing at 7%. The prudent decision would be to wait for the full effects of this event to feed through and then reconsider taking a position.