Updated: Sep 1
C3S Paper No. 0031/2016
The following is text of a presentation made by the author at Observer Research Foundation, Chennai on February 13 2016.
Established in 1991, China’s stock market is the youngest in the world. The London Exchange dates back to the sixteenth century and the New York Exchange to the late eighteenth.Our own BSE dates back to 1875. Though the youngest, since its opening in Shanghai and Shenzhen, it has become the second largest exchangein the world with a market capitalization of $6 trillion in 2014.
Main exchanges are Shanghai (SSE) and Shenzhen (SZSE). The SSE has around 1000 listed firms and the SZSE has around 1500.There are two other exchanges: The Small and Medium Board (SME Board) and ChiNext (Gem), both under the SZSE. The SME has over 750 listed companies and GEM focusses on smaller high-technology and innovation firms. There is a New Third Board set up in 2014 to exchange the equities of smaller firms that may not meet the listing requirements of major boards.
China’s stock market has a number of special features. Unlike exchanges in the west which are quote-driven, China’s exchanges are order-driven. All the exchanges are centralized unlike in the U.S. where the markets are fragmented. The U.S. has multiple exchanges, dark pools and other off-exchange trading which increase market information. In China, there are no hidden pools with hidden orders and all orders are visible. Shadow banks play a big role. However,retail and institutional investors are treated alike and have equal access to information from the market at a micro level. Macro concerns are hardly visible. Wu Jinglian, a famous Chinese economist, characterized it as a “casino”. Millions of individuals dabbling in stocks are not even matriculates, according to one survey. Further, China’s stock market has a daily price change limit of 10% which is intended to reduce excess volatility and deter price manipulation.
One of the special features of China’s stock market is that it is a dual-share system: domestic investors can invest only in A shares and foreign investors can invest only in B shares. In addition, many firms have H shares, traded on the Hong Kong Stock Exchange. Several studies suggest that there is price discount of B shares and H shares relative to A shares. This is attributed to information asymmetry between foreign and domestic investors and speculative motives. With a view to open up and modernize its financial system, especially under pressure from the U.S. in the SED (Us.-China Strategic Economic Dialogue) negotiations, China created a new facility in 2002 named Qualified Foreign Institutional Investors (QFII). This is comparable to the Foreign Institutional Investor (FI) facility in India.
The main stock exchanges, SSE and SZSE, consist largely of state-owned enterprises, including banks, insurers, oil and gas, manufacturers and information technology firms. SSE also allows issue of bonds, including T-bonds and corporate bonds, and trading for funds. As on July 2015, data showed the following:
SSE SZSE ChiNext
Firms listed 1057 1619 485
Market Caps. $4.5 trillion $3 trillion $700 bn.
Median market cap. $1.2 trillion $1 trillion $930 bn.
Median/PE ratio 40 61 75
(Data source: Primer on China’s stock markets, Peterson Institutefor International Economics, July 8th, 2015.)
These data suggest that the median price-to-earning (P/E) ratio of the SZSE was high at 61. It signaled that the market values had gone too far.
The rebalancing policies of the government would queer the pitch further and bloat stock values more. These policies were a part of the 12th Five Year Plan and were also based on advice from the international community, including the World Bank that China should move from its export-oriented and investment-driven policy model to one which looks inwards and raises the growth of other sectors such as services and also rely more and more on domestic demand. This policy model was also approved by the Third Plenum of the Eighteenth Conference of the Communist Party of China. Xi Jinping is committed to continue the reform policies under his leadership and affirmed it while negotiating with the IMF and the US government on the major issue of getting Renminbhi (RMB) or Yuan included in the SDR basket.
Even as China had commenced its efforts to rebalance and turn inwards, the Great Recession of 2008 intervened. Global demand shrank precipitously and China could not maintain its high rates of growth relying on exports. It had perforce to turn inward and raise domestic demand to fill the gap created by declining exports. It stepped up domestic investment with its bailout package of $590 billion. In effect, this meant China was using monetary policy, state-owned banks, local governments and other tools under its control to push internal investment. It also implied a greater reliance on stock markets. Many regulations were relaxed. By mid-2014, the PBoC and other regulatory agencies began to ease financing conditions as the economy continued to deleverage from post-crisis credit boom. There were cuts in deposit rate and in reserve ratio along with several rounds of regulatory loosening to boost the capital markets.
It was explained by many analysts such as Ruchir Sharma of Morgan Stanley that there was a plan behind these. They wanted to clean up the balance sheets of heavily indebted SOEs (State-owned Enterprises) by raising money through stock issues. They were expecting to clear government debt through SOE divestures. This is similar to our own government’s efforts to fill budgetary deficits through PSU divestures. Moreover, Chinese people have a high saving rate of over 50 percent and these can be drawn into the stock market. It seemed to be a part of X iJinping’s “Chinese Dream” (zhongguo meng) that citizens should become shareholders for a better life! It appeared, as alleged by some critics, Chinese authorities implicitly underwrote stock returns and would, if necessary, resort to state intervention.
Unlike other countries, China’s stocks are driven by bank credit, i.e. margin money. Investing borrowed money was restricted in the earlier years. Regulations were loosened since 2010, especially after 2014 and there was an explosion of debt-fueled trading. Around 2014, margin debt tripled. In a Wall Street Journal piece Sharma assessed “as a share of tradable stocks, margin debt is now nearly 9%, the highest in any market in history.”In the U.S. it was 3% around that period.
China’s stocks had become the toast of fund managers and investment banks in the west and they drooled over them. The BRICS myth promoted by Goldman Sachs was a part of this game.The market peaked on June 12, 2015, and Shanghai stock index rose by more than 135% in one year. As Michael Pettis put it, “The boom seemed almost inexplicable from a fundamental point of view.” It was a time when growth expectations for China fell, corporate profitability was squeezed and banks, who dominate the index, saw sharp rise in their non-performing loans. Some other analysts like Orville Schell of the Guardian had foreseen the bubble. Among other factors was what he called “Party cheer-leading the market’s inexorable rise.” The Economist carried a report (The bubble question, April 14, 2015) and drew attention to the fact that the bubble had crossed China’s borders into Hong Kong H shares soared by 20%.
On July 7, 2015, described as “Black Tuesday”, the market crashed and the values fell by one third, though they were yet 80% over the previous year.There was panic in the market and it spread to other markets in Asia, Europe and the U.S.
Chinese authorities began to intervene in the market aggressively. These have been described by this author in two separate papers. (Chinese Stock Market Tantrums To control or not to control, C3S Paper No.000/2016; The circuit breakers that failed, C3S Paper 0013/2016.)
Impact on China
The global market, in particular the global press, had over reacted. China lost $5 trillion in the equity market rut in two months. As one report of Bloomberg said, “..measured by the intensity of the price swings, the selloff still fails to stand out among past market meltdowns.” The fluctuations were assessed to be 30% lower than the average of six financial crashes, including the ones in 1929 in the U.S., Japan in the early 1990s and Thailand in 1997. The report characterized it as market correction and no financial crisis. It was largely a price adjustment to a frothy valuation following a more than 150 percent surge.
What has been the impact of stock market volatility on China’s growth? This is a complex issue and there have been wild differences of opinion among economists. There are the neo-liberal economists who see the role of the stock market in raising capital and efficiently allocating it. Drop in capital raising would reduce growth rate, perhaps, with a time lag. This is too abstract and theoretical a view and does not seem to hold good under current conditions of excessive financial/capital flows. Rather, it creates a disjunction between the financial economy and the real economy. Stock values do not reflect the fundamentals underlying the economy. As narrated earlier, China’s stock market boomed paradoxically at a time when the growth had started declining.
After the stock crash, in a brief analysis PIIE (Peterson Institute for International Economics, July 12, 2015) suggested that a 30 percentage point fall in stock prices in China would be associated with 1.14 percentage point slower growth rate.
In a later study, PIIE (China’s Growth: Still Envy of the World Despite Slowdown, January 21st, 2016) explained how some of their economists “are skeptical that stock market decline conveys any novel information about the Chinese economy in 2016.” Many of the factors contributing to the gradual slowing of China’s growth rate – from rising labor costs to rebalancing towards the service sector- are both natural and desirable. Even the IMF in its World Economic Outlook UPDATE (January 19, 2016) kept the rate at 6.3 percent for 2016 and 6.0 percent in 2017. “Volatility in equity markets can exacerbate legitimate fears about the challenges facing the Chinese economy, but it is hardly shocking that first time retail investors would pursue momentum-chasing strategies. Economic fundamentals do not suggest a sharp decline in the economy. Nicholas Lardy, an old China specialist, added that the 43% decline in Shanghai index had little measurable effect on China’s real economy. Growth was down by a tenth of a percentage point compared to the first half. The services sector actually strengthened on the back of stronger private expenditures based on the growth of disposable income. Unlike the U.S. there is no “wealth effect” to impact adversely on the economy.
China’s stock market plays only a smaller role in financing the real economy. In 2015, its domestic stock market supplied Rmb 760 bn. in funding to non-financial firms, through initial public offerings (IPOs) and it represented 5% of the total financing flows to the real economy. On the other hand, credit in the economy has boomed since 2008 under the stimulus and the stock of social financing as a proportion of GDP has increased by 88 percent while equity financing has increased by 3 percentage points. After the stock crisis, the banks began to run the financial system. Bank loans made up 69 percent of new financing. Banks have deep pockets and there is no drying up of credit. Indeed, this leads to questions or doubts about China’s commitment to undertake financial sector reforms. There are fears that equity market is dead and the manner in which China Securities Regulatory Commission (CSRC) handled the crisis destroyed them!
What are the global implications? On 4th as well as 7th January 2016 when China’s stock crashed, global stock markets were rattled beyond measure and stocks lost around $2.5 trillion in value. The impact was varied in markets stretching across Asia to Europe and the U.S. Sensex ended 2.18 percent And NIFTY at 2.23 percent, a 19 month low. Rupee was also affected along with other Asian currencies. Rupee touched a three week intra-day low of 66.96 to a dollar as foreign funds continued their exit from emerging markets. Outward capital flows had commenced long before China’s stock market hiccups and were triggered by longer-term factors. A great part of it was due to China’s slowdown and its impact on some developing countries exporting heavily to China. The trend had commenced two or three years earlier and had nothing to with China’s stock market volatility.However, an important factor was that equities are held by fund managers who had heavily invested in China and BRIC countries seeking higher returns at a time when western markets were in doldrums. Now they were in panic and began to shift funds back home or to safer havens like Treasuries. It is not often recognized by neo-liberal theorist that they are also subject to the same herd mentality attributed to retail investors. When the flight back home commenced, they were ready to use ‘flash trade’ and other methods to move out as fast as they can.
Data on direct financial involvement of western investors are hard to come by. There were reports that foreign banks had lent over $1 trillion to Chinese public and private companies. They were concentrated in Hong Kong, UK, US and Japan. Most of these may be in high technology companies which are still having high stock valuations. However, hedge funds held equity directly or through Exchange Traded Funds were raking up double digit returns two months before the crash. They withdrew from the market and would have absorbed the partial loss without difficulty in their global books.
The global impact of China’s stock crisis is minimal and much exaggerated. There were other macro-economic factors at work around the same time. Crude oil price began a decline which continues unabated, from $100 per barrel to $30 now. It had its impact on dollar rate.
China began to work on a new system for the Yuan exchange rate based on a basket of currencies. There were doubts or ambiguities about the new model. Christine Lagarde of the IMF had to intervene and assure the financial community that it was a positive move in line with the marketization efforts of China.
Bond markets were in trouble with deleveraging pressures from banks. Asset values had been distorted by the Quantitative Easing (QE) policies of the Fed and ECB and exit from QEs set in its train uncertainties in the financial market and created extreme volatility. Dr.Raghuram Rajan put it rather bluntly at Davos: “Ultra interest rates and similar policies were successful in averting a second Great Recession but are now creating distortions in markets for bonds, stocks and currencies.”
Compared to all these, the impact of China’s stock crisis on the market was indeed negligible. Unfortunately, it was easy to lay all the blame at China’s doors.
A consensus view which is unrelated to the stock crisis is the slowdown of China’s economy. This has led to decline in commodity prices and the fall in volume and value of commodities affect seriously some countries like Brazil, Australia, etc. which were heavily dependent on exports to China. Some argue that a China growing at 6 percent or even less is an engine of growth. Markets are nervous because if China goes, the U.S. and the rest of the world cannot compensate for that.
Naturally, China Crisis was a subject matter of debate in the Davos Economic Forum held last month.
Responding to a question on the outlook for reform of SOEs, she said that despite the size of the challenge, she believed that Beijing would deliver such reforms. She referred to the intensive discussions on Yuan’s entry into the SDR basket and how China had met it commitments for entry.
Blending western type stock markets into the regulatory economy like China’s is throwing up newer challenges. This may well become a part of the ongoing debate within China on the progress of “reforms’ laid out in the Third Plenum. It is truly a test of Xi Jingping’s leadership.