China’s Stock Market Crash
Condensed from Satyajit Das’s three-part article on www.economonitor.com. Between 2013 and mid-2015, the Shanghai Stock Exchange Composite Index rose by around 250% then fell sharply by around 30%. There were similar episodes in 2001 and in 2007/2008 when the benchmark Shanghai Composite index also topped 5,000 rising 90% before falling 70%.
Chinese stock markets are complex, involving multiple types of shares and convoluted ownership arrangements. There are A-shares: Renminbi denominated shares in mainland China-based companies whose ownership is restricted to mainland citizens and foreigners under the regulated Qualified Foreign Institutional Investor (QFII) system. There are B-shares which are quoted in foreign currencies (such as the US dollar) and can be purchased by domestic and foreign investors (with a foreign currency account). There are H-shares: Hong Kong dollars denominated shares in Chinese companies which are listed in and trade on the Hong Kong Stock Exchange.
There are even shares which are not really shares, such as the rights in Variable Interest Entity used by foreigners to get around ownership prohibitions to acquire stakes in Chinese Internet companies like Alibaba. These are typically Cayman Islands companies which use contracts to provide an economic interest in a Chinese business. In the case of Alibaba, its Chinese assets are owned by founder Jack Ma and other related parties. The Cayman Islands Company has contractual rights to the profits of Alibaba China. Such rights may be deemed illegal by Chinese authorities or be unenforceable. It is also difficult to protect the business assets and earnings from actions by the legal owners.
The stock market itself is relatively unimportant within the Chinese system. The vast majority of funding is in the form debt, primarily from banks, with equity issues contributing 5-10% of all capital raisings. Historically, the total free float value (shares available for trading) in China is around 25-35% of Gross Domestic Product, well below the levels in the US (150%) and most developed economies (85-100%). Retail investment is modest with only around 10-20% of household wealth being held in the form of shares, well below levels in developed countries.
Chinese stock markets are also different. Around 30% of the value of the Shanghai market is made up of large companies. Most are government related, where a large proportion of shares are held by state firms and government agencies. The rest of market is made up of numerous small and medium sized enterprises. It is these small and medium capitalisation stocks which attract many investors. The recent stock rises were mainly in these smaller stocks which increased by 100-400%. In contrast, the prices of larger mainland companies rose by a more modest 20-30% during the corresponding period.
The investment environment is also different. 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. Unanticipated government intervention to achieve policy objectives is not unusual.
In an interesting reversal to the experience in developed economies, the performance of the Chinese stock market did not match its stellar economic growth until the recent boom. In the past 20-25 years, investors have earned a modest 1-2% per annum. In the 20 years commencing June 1993, the Chinese stock market rose around 20% until the recent sharp increase, compared to gains of around 400-500% in the S&P 500 and over 300% in emerging markets. The Shanghai market was until recently valued at around 6-8 times earnings, well below the 12-15 times of international markets. Investors, especially international fund managers, saw the market as undervalued.
But the primary factor behind the boom was government policy. The A-share bubble was engineered to compensate for China’s slowing economic growth. The government introduced targeted easing of interest rates and loosened restrictions on lending to boost growth as well as manage the reduction of shadow banking and slowdown in the property sector. Lower rates helped fuel the rise in stock.
Higher shares 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 US$100 billion in initial and secondary stock offerings.
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, policy makers encouraged the creation of exchanges to become a funding source for start-ups and innovative companies. The state-controlled news media supported the policy, publishing favourable pieces on the prospects of the technology and Internet sector. Investors invested believing that the government would ensure that shares prices would keep rising.
Chinese policy makers, historically, have played an important role in directing savings into specific assets 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.
The Chinese government’s policy to boost stock prices succeeded beyond expectations as investors fuelled a speculative boom. Prices rose around 250% in around 2 years, including a rise of 26% 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.
There were a number of factors behind the rise. Greater access saw increased international participation, particularly from Hong Kong. Technical factors played a part. ChiNext, a market for start-ups, more than tripled in the period after mid-2014 because of an anomaly. Regulators responsible for approving initial public offering were unable to keep up with the rise in businesses seeking to list.
To get around this problem, already listed firms operated as listing or financing vehicles. Investors drove their prices up, using the shares as currency to buy businesses awaiting listing. One flooring company reinvented itself as an online-gaming business. A pyrotechnic firm mutated into a peer-to-peer lending business. As result, the prices on ChiNext reached around 150 times earnings, comparable to the NASDAQ at the height of the internet boom.
Retail (individual) 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% of daily trading. There are probably over 100 million share trading accounts (around 8% of the total population) compared to 88 million members of its Communist Party. The penetration of and access to the internet and mobile telephony also assisted the growth of stock trading.
The average investor is middle to low income, with over 60% lacking a high school diploma. Retirees, farmers, office workers, housewives and students feature prominently. 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.
In June 2015, prices corrected. There was no clear single factor that appears to have triggered the price falls. Investors simply lost confidenc with a market increasingly driven by debt fuelled liquidity and manic speculation. Valuations had become stretched with the rise in share prices at odds with slowing economic growth and deterioration in corporate earnings. New initial public offerings were oversubscribed, in some case by 240 times the shares on offer, but purchasing new listings increasingly required investors to sell existing investments, creating selling pressure.
The effect of falling prices was amplified by the leverage created by widespread access to margin loans. The government in conjunction with Chinese exchanges established China Securities Finance Corporation in 2011, a state controlled body that lends to securities brokerages to support their margin lending to stock investors.
At its peak, margin loans reached around US$350 billion or 12-14% of the size of the stock market. In comparison, the level of margin loans in the US is around 5-6% and 1% in Japan. Falling prices triggered margin calls and forced liquidation of positions as investors needed to raise cash or 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. Chinese media blamed short sellers and market manipulators. Patriotic calls sought to discourage investors betting on price falls. Chinese police instigated ritual investigations 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.
Given the limited effect of these measures, the government intervened more directly in the market. The government-controlled Securities Association of China arranged for the 21 big brokerage firms to establish a fund worth around US$20 billion, to buy shares in large companies. China’s securities regulator ordered major shareholders (with stakes exceeding 5%), corporate executives, and directors from selling their shares for six months. State owned enterprises (“SOE”) and investment vehicles were instructed not to sell shares. There were suggestions that some SOEs may have bought back their own shares to support prices. New listings were deferred 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 US$$2.5 trillion worth of shares or 40 percent of the stock market capitalization. Eventually, the market stabilised, but the intervention primarily assisted the share prices of big SOEs like PetroChina. The broader market, particularly small-capitalisation stocks, remains fragile.
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 (US$4 trillion) and the ability to use state controlled banks to expand their balance sheets provides the government with significant resources to purchase shares.
Still, China’s ability to intervene has constraints. Expansion of credit risks increasing inflationary pressures and also further 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. For the moment, even after the 40% fall, the Chinese market remains above its mid-2014 levels. The outlook is unclear, because of the inability to trade in around half of all listed companies.
The impact on the real economy has been muted to date but it is incorrect to assume that the fall will have no effects. To the extent that wealth losses have occurred and uncertainty has risen, Chinese households may increase already high saving rates reducing consumption and slowing growth. The output of the finance industry contributed around 16% of GDP in the first quarter of 2015. It accounted for 1.3% of China’s 7% growth in the same period, compared to a contribution of about 0.7% to the 7.4 percent growth in 2014. The slowdown will affect growth in future periods.
The financial effects may be greater. The consensus view is that margin loans are modest relative to the size of the banks (around 1.5% of total banking assets) and the economy, implying the risk of a major financial crisis is limited. But there are reasons for caution. First, the amounts involved may be much larger than expected. The amount of official margin debt extended by securities companies of US$250-300 billion may only be a fraction of the real level of stock secured debt. Once vehicles like umbrella trusts, private lending arrangements etc. are included the amount may be 50-100% higher.
Second, the exposure of the banks is greater than commonly assumed. Around 60-70% of all lending in China is from banks. While precluded from direct exposure to stocks, banks have significant exposure to securities companies, broking firms, investment funds and trust companies which provide margin financing. Banks also finance listed companies where the collateral securing the loan is stocks. General purpose bank loans to household and companies may have been used to buy stocks. Problems may emerge over time.
Third, the official permitted level of leverage is a modest 2 times or loans totalling 50% of the value of the stocks. In reality, real leverage was higher. In addition, there were multiple layers of leverage. Investors would borrow funds from bank using the borrowed funds as the capital to purchase shares on margin.
The financial exposures derive from an essential circularity in the engineering of the stock boom. The intention was to use higher stock prices to allow heavily indebted entities to raise equity to pay back otherwise unsustainable borrowing, in effect reducing the risk of loss of banks. Instead, the banks were lending money directly or indirectly to investors to buy shares where the proceeds may have been used to pay back the bank. The banks had just exchanged risks without necessarily reducing the risk of loss. The circularity has been compounded further after the share market falls. China’s biggest state-owned banks, under government encouragement, have lent over US$200 billion to the country’s margin finance agency to support share prices.
Chinese real estate represents around 23% of GDP, about three times that of the US at the height of its property bubble. Prices appear inflated relative to incomes and rental yields. Despite vacancy rates of over 20% and inventories equivalent to 5 years demand in some cities, new housing starts are around 12% above sales. In China, investment spending as a percentage of GDP is unprecedented in history, creating massive overcapacity.
The accompanying credit bubble remains an immediate concern. By 2014, total Chinese debt was US$28 trillion (282 percent of GDP), higher than comparable levels in the US, Canada, Germany and Australia. In comparison, China’s debt was US$7 trillion (158 percent of GDP) in 2007 and US$2 trillion (121 percent of GDP) in 2000. This increase in its debt of by more than US$20 trillion since 2007 is approximately one-third of the total rise in global debt over the period. The problem is compounded by the use of this debt to finance assets with inadequate returns to meet interest and principal repayments.
While in isolation a significant but perhaps manageable problem, the stock market falls especially if the Chinese authorities are unable to bring it under control will ultimately affect China’s potential growth which has, since 2009, contributed significantly to global economic activity. This concern is reflected in significant falls in global resources stocks, as investors anticipate a slowing demand for commodities.
The real damage is subtler bringing into question the fundamental economic model, the reform agenda and the political authority of its leadership. Instead of diverting attention from existing challenges, the stock market correction has drawn attention to challenges such as the end of property boom and other challenges.
China’s financial system is predicated on directing savings of ordinary Chinese into areas for policy purposes, especially maintaining economic growth. The regime relies on keeping the cost of funds artificially low, usually below inflation rates. The system allows Communist Party connected firms and privileged insiders to benefit.
The stock market boom allowed elites to access cash from Chinese savers. The first group who benefitted were those who were able to list or sell shares to take advantage of artificially high prices. The second group were those who gained preferential access to shares in hot listings or benefitted from private information about earnings and corporate actions.
The fall in prices affects both groups. The financial elite are deprived of easy money making options, especially as other sources of profits such as property are unavailable. Ordinary savers encouraged by the government to invest in stocks face large losses, increasing resentment at the nature of the game and growing wealth gap.
What was so spectacularly unique was the way an economy (China, post-GFC) that amounted to 15-20 per cent of the global economy was able to record sustained growth rates of 8 per cent when the developed world was in its worst recession since the 1930s.
Now we are seeing the consequences of that massive stimulus — Chinese over-capacity after the over-investment.
Broadly we are seeing two major impacts: on commodity markets, and on global capital markets and capital and investment flows. The first obviously is the big fall in commodity prices; the second in both capital flows out of China and volatility in developed world capital flows.
One of the few forecasters to predict both the start and peak of China’s equity boom, is now warning the nation will be buffeted by the same forces that caused financial crises around the world over the past four decades.
Hao Hong, chief China strategist at Bocom International Holdings Co. in Hong Kong, says a shortage of dollars was the common feature in the oil rout in the 1970s, Latin American debt turmoil in the 1980s, the Asian currencies collapse in 1997 and the global crisis in 2008. Next year will see Federal Reserve interest-rate increases, an improving U.S. current-account balance and a stronger greenback, putting strains on the most-leveraged parts of the world’s second-largest economy, he says.
“Historically, every time the U.S. current account improved, concurrent with dollar strength, some country somewhere in the world plunged into some sort of crisis,” Hong said. “The pressure from a Fed tightening and thus a dollar liquidity shortage scenario will more likely show up” in Hong Kong property as well as China’s online lending and high-yield corporate bonds, he said in an interview.
The yield premium that investors demand to hold dollar-denominated high-yield Chinese bonds over U.S. Treasuries declined to a two-year low of 607 basis points in October and was at 705 basis points on Dec. 22, according to Bank of America Merrill Lynch data. The credit spread is “not enough to justify its risks,” Hong said.
Chinese companies are struggling to generate the cash flow needed to service their obligations as economic growth slows to the weakest pace in 25 years and corporate profits shrink. While the debt burden has been eased by six central bank interest-rate cuts in 12 months and a tumble in corporate borrowing costs to five-year lows, the number of defaults is on the rise. The amount of bad debt reported by Chinese banks rose 10 percent in the third quarter from the previous three months to 1.2 trillion yuan.
The prospect of further easing in China and interest-rate increases in the U.S. risks accelerating capital outflows. In the U.S., Federal Reserve officials forecast borrowing costs will rise to 1.375 percent by the end of 2016, implying four 0.25 percentage point moves.