Given debt and leverage is one of the biggest issues facing the Chinese economy, one might wonder why the Chinese government would allow even more of it to inflate an equity bubble.
Large gap between Chinese A-shares and H-shares
Boom and bust of the Chinese local stock market
The boldest headlines were clearly reserved for Greece in the past weeks, but events in China are potentially much more worrisome for global financial markets.
Healthy equity markets are an important component of the Chinese government’s broader plans to reduce debt in the economy. Strong markets allow China to sell stakes in state-owned enterprises (SOEs) through initial public offerings (IPOs) and to do other forms of equity raising, effectively converting debt into equity. By encouraging retail investors to participate without monitoring leverage levels, the local markets rallied by more than 130% in a few months fuelled by ballooning margin trading as private investors borrowed money to invest in stocks. When the authorities woke up to the issue and tried to reign in leverage, it pricked the bubble it had created. It is not a coincidence that the rise and fall in the Shanghai Composite Index exactly mirrors the increase and then contraction of margin lending by Chinese brokerages. On the way down, leveraged investors unwound their holdings to repay their loans, amplifying the crash. Shanghai listed A-shares have lost 27% since its peak on June 12, the worst sell-off in two decades. About US$ 3.9 trillion in market valuation has evaporated, 16 times Greece’s gross domestic product.
Differences between A-shares and H-shares
The local A-share market is China’s largest stock market. It is dominated by domestic retail investors (about 85%) and is only gradually opened up to international investors. It is not part of the MSCI Emerging Markets Index. Foreign equity investors typically have exposure to China through Hong Kong listed stocks. The Hang Seng China Enterprises Index (HSCEI) tracks the performance of these ‘H-shares’, which are part of the MSCI Emerging Markets index. Most Chinese companies trading on the international H-share market, also trade on the local A-share markets. Dual-listed Chinese stocks are trading at a 47% premium on the A-share market, indicating a clear difference between foreign and domestic investors in estimating the valuation of the companies. Volatility in H-shares was considerably lower (see graph). The market behaves maturely and stocks stayed trading despite the volatility, with none of the suspensions we saw on the mainland. Since the pullback, the HSCEI Index is now trading below 9 times earnings. A-shares are still far more expensive: the Shenzhen Composite trades at a price/earnings ratio of 47 while the Shanghai Stock market trades at 19 times earnings.
Wide range of measures to stop the correction
The authorities did several attempts to stop the correction in A-shares, such as another policy rate cut, liquidity support for margin buying, using state funds to buy shares directly and postponing planned initial public offerings (IPOs). These measures were largely unsuccessful. More drastic measures were announced last week. The China Securities Regulatory Commission (CSRC) banned major shareholders, corporate executives, and directors from selling stakes in listed companies for six months. Moreover, trading in more than half the shares in the onshore A-share markets was suspended. These measures seem to have halted a further sell-off for the moment and we even saw a bit of a rebound on July 9 and 10. It remains to be seen if the markets will calm down in the coming weeks.
The government seems determined to stabilize the market and to support the economy with further stimulus measures. However, the recent actions may have a negative impact in the longer term.
Has the Chinese government lost its magic touch?
There is a perception in China and the rest of Asia that Chinese policy makers are infallible and through its close control of the economy, China can pretty much drive whatever outcomes it wants. While that’s truer for China than many other countries and governments, the failure to stop the correction demonstrates that there are limits even to Chinese policy. The main surprise is not so much about the raft of intervention measures that the government has tried to use, nor that it has been largely unsuccessful, but that the authorities allowed margin trading and leverage in the stock market to the extent that it did. Given debt and leverage is one of the biggest issues facing the Chinese economy, one must wonder why the government would allow even more of it to inflate an equity bubble. At best, it may have seriously underestimated the degree of unofficial or "shadow" margin lending – which does not reflect well on its reputation for control.
Deteriorating investor sentiment has serious consequences
This loss of credibility comes at a particularly bad moment, now that the economic policy easing of the past quarters should start to yield results. A serious deterioration in investor sentiment is likely to affect business and consumer confidence. The economy, which has been so weak in the past quarters, might not stabilise now.
Domestic investors might also be shocked by the apparent inability of the government to control the market that we go into another long period of domestic indifference to equities as an asset class, as we saw after the 2007/2008 boom and bust in China. That would have other consequences, for example if the IPO market froze over again it would be a major problem for the government when they have to postpone their plan to swap debt for equity through numerous and large IPOs. As a result, indebtedness in China will continue to accelerate, which means that the pressure on the banks will continue to increase.
Also the trade suspension of so many A-shares is a reputational blow for the Chinese ambition to play a bigger role on international financial markets. It does beg questions about whether the onshore market is sufficiently mature for inclusion in major global indices. It could thus affect MSCI's future decision on inclusion China A-shares into its global benchmark indexes. Furthermore, the huge volatility shows that China is not yet able to provide an attractive savings market for its population.
Hong Kong listed stocks offer value
A combination of the unwinding of leverage – which caused the problem in the first place – and the fact that the policy response is now immense will possibly see markets bottom around current levels. While valuations of the mainland markets are still high, Chinese H-shares are reasonably valued. Hong Kong listed Chinese stocks include companies with strong balance sheets, stable cash flows and secure dividends. Within global emerging markets this looks attractive.