The eternal mystery of volatile Chinese markets

Image: Sameer Pawar

Oriental mystery swathes everything in China, including its stock market.

Between 2013 and mid-2015, the Shanghai Stock Exchange Composite Index rose by around 250 percent from around 2,000 to over 5,000. Since reaching its peak in June 2015, the indices have fallen sharply, by around 40 percent. The loss equates to around $3-4 trillion. The phenomenon is not new. In 2007-2008, the Shanghai index also topped 5,000, a rise of 90 percent followed by a fall of 70 percent.

Taking stock
Chinese stock markets are complex, involving multiple types of shares (A, B and H) and convoluted ownership arrangements. The stock market itself is relatively unimportant within the Chinese system. Equity issues contribute 5-10 percent of all capital raisings. The vast majority of funding is in the form of debt, primarily from banks. The stock market is small relative to the size of the economy. Historically, the total free float value (shares available for trading) in China is around 25-35 percent of the GDP, well below the levels in the US (150 percent) and most developed economies (85-100 percent).

Retail investment is modest with only around 10-20 percent of household wealth being held in shares, well below the levels in developed countries. Less than 10 percent of Chinese households actively trade shares while another four percent are exposed to the stock market through mutual funds.

Around 30 percent of the value of the Shanghai market is made up of large companies. Many are government-related, where a large proportion of shares is held by state firms and government agencies. The rest of the market is made up of numerous small and medium-sized enterprises. It is these small and medium capitalisation stocks that attract many investors. The recent stock rises were mainly in these smaller stocks, which increased by 100-400 percent. In contrast, the prices of larger mainland companies rose by a more modest 20-30 percent during the corresponding period.

Regulation is poor, with many companies listing on Chinese exchanges where they would be unable to meet the more stringent requirements of overseas exchanges, such as Hong Kong or the US. Company-specific financial disclosure, dividend payments, audits, governance and protection of shareholder rights are poor. Unanticipated government intervention to achieve policy objectives is not unusual.

Engineering the boom
The primary factor behind the boom was government policy. Investors believed that the government would ensure that share prices would keep rising.

The Chinese political and economic system since Deng Xiaoping has been held together by a simple contract. The Chinese Communist Party’s political control was recognised. In return, the population, at least the majority, would see improvements in their material living standards. A few well-connected insiders and a growing middle class would be allowed to accumulate wealth. The A-share bubble was engineered to compensate for China’s growing economic problems, which threatened this tacit arrangement.

China’s economic growth has slowed. It is now forecast to be around seven percent, well below the nearly 12 percent growth it averaged between 2002 and 2008 and 8-9 percent since 2008. The real estate market, which was a significant source of increasing wealth, is no longer booming. Prices are down by around 20-30 percent. The government has restricted wealth management products offered by China’s shadow banking system and limited higher returning investment opportunities for investors looking to protect their purchasing power.

The government undertook targeted easing of interest rates and loosening restrictions on lending to boost growth as well as help manage the reduction of shadow banking and slowdown in the property sector. Lower rates helped fuel the rise in stock.

Higher share prices were also intended to assist heavily indebted property companies, local government financing vehicles and state-owned businesses. Favourable stock markets would enable these businesses to raise equity to pay back bank borrowings. Taking advantage of conditions, Chinese companies have raised around $100 billion in initial and secondary stock offerings.

A more charitable interpretation would argue that the development of equity markets was part of a broader reform agenda. It was intended to rebalance the financial system from its excessive reliance of bank loans and create a dynamic stock market to finance future growth. As part of this agenda, policymakers were encouraging the creation of exchanges to become a funding source for startups and innovative companies. The state-controlled news media supported the policy, publishing favourable pieces on the prospects of the technology and internet sector.

In a sop to international pressure regarding deregulation, China also increased the limit for foreign funds investment to $150 billion (from $80 billion). It also established a trading link between the Shanghai and Hong Kong exchanges to allow foreigners greater access to Chinese stocks.

Chinese policymakers, historically, have played an important role in directing savings into specific asset classes or investments as part of their management of the economy. The engineered stock market rise was a continuation of that process. The process quickly spun out of control. It was like “drinking poison to quench one’s thirst”, as one old Chinese proverb goes.

Going up
Government policies succeeded beyond expectations in boosting the stock market as investors fuelled a speculative boom. Prices rose by around 250 percent in about two years, including a rise of 26 percent in a single month. Daily turnover quadrupled. At one stage, over 500,000 new trading accounts were being opened weekly. The Chinese stock market increased in size rapidly, overtaking Japan to become the second largest stock market in the world.

Retail investors played a major role in the rise of share prices. In the reverse of the position in developed equity markets, Chinese retail investors, rather than institutions, dominate turnover, accounting for up to 90 percent of daily trading. There are probably over 100 million share trading accounts (around eight percent of the total population), which compare favourably to the 88 million members of its Communist Party.

The average investor is middle to low income, with over 60 percent lacking a high school diploma. Much of the trading is speculative, driven by the lure of seemingly easy money. A high percentage of activity is short term in orientation, with very high levels of intra-day activity. At the height of the boom, trading activity on Chinese exchanges exceeded that of the rest of world’s stock markets.

Trading was driven by superstition, including astrology, numerology and charms. Echoing the conditions prior to the 1929 crash, one investor admitted to investing on the advice of her hairdresser: “It was still a bull market and I needed to get in.”

Going down
In June 2015, prices corrected. There is no clear single factor that appears to have triggered the fall. The market simply ran out of momentum and investors lost confidence.

The effect of falling prices was amplified by leverage, in the form of margin loans. At its peak, margin loans reached around $350 billion, around 12-14 percent of the size of the stock market. In comparison, the level of margin loans in the US is around 5-6 percent and one percent in Japan. Falling prices triggered margin calls, forcing liquidation of positions as investors needed to raise cash; else they could not meet demands for additional collateral.

As the market fell with increasing rapidity and price changes became disorderly, Chinese authorities responded with a mixture of communist propaganda and borrowed capitalist tricks. The media blamed short sellers and market manipulators. Patriotic calls sought to discourage investors betting on price falls. The Chinese police instigated ritual probe into short selling to scare even legitimate sellers out of positions.

Following the emergency plunge protection guidelines patented by the US authorities, the Chinese central bank pumped money into the financial system. Interest rates were cut. The reserve ratio and loan to deposit limits were altered to allow banks to increase lending. Margin finance rules were relaxed allowing anything from real estate to antiques to be used as collateral for loans.

As the rout continued, the government-controlled Securities Association of China arranged for 21 big brokerage firms to establish a fund worth around $20 billion to buy shares in large companies. China’s securities regulator ordered major shareholders (with stakes exceeding five percent), corporate executives, and directors against selling their shares for six months. State-owned enterprises (SOEs) and investment vehicles were instructed not to sell shares. There were suggestions that some SOEs may buy back their own shares to support prices. New listings were deferred. With currently planned share offerings of over $600 billion, the authorities sought to limit the claims on available investor funds.

The government encouraged companies to apply for trading halts. This resulted in suspension of trading in around 1,400 companies listed on Chinese exchanges, representing over $2.5 trillion worth of shares or 40 percent of the stock market capitalisation.
                                                                
Eventually, the market stabilised. The intervention primarily assisted the share prices of big SOEs, such as PetroChina. The broader market, particularly small-capitalisation stocks, remains fragile. After the 40 percent fall, the Chinese market remains above its mid-2014 levels. Prices remain volatile.

But Chinese stock market valuations remain stretched. Even after the recent decreases, Chinese shares, particularly in technology firms, are not cheap. The post-crash median valuation of stocks on the Shanghai and Shenzhen exchanges is almost three times that of the companies listed on the Standard & Poor’s 500-stock index. Margin debt levels remain high.

Given the centralised political and economic command and control in China, it is unwise to assume that the authorities cannot prop up share markets. Large foreign exchange reserves ($4 trillion) and the ability to use state-controlled banks to expand their balance sheets provide the government with resources to purchase shares. But expansion of credit risks increasing inflationary pressures and complicating the task of dealing with a large pre-existing credit bubble. Intervention might push up the value of the Chinese yuan, making China’s embattled exporters even less competitive.

Chinese authorities are discovering an old truth—bubbles are hard to see and even harder to catch.

Satyajit Das is a former banker whose latest book Age of Stagnation will be released in India in November 2015