China’s competence to manage equity markets is substantially in question following the country’s effort to prop up stock prices earlier this month. China’s policy makers may have shown effective crisis management, but the rest of the world now knows how poor they are at preventing crises. Financial stability will come — but at the cost of a liquid stock market.
The Chinese government brought about a de facto quasi-nationalization of almost 7% of the stock market (as of late-July prices). This is comparable to the Hong Kong authorities’ buying up of 11% of the Hang Seng market capitalization in 1998, which ended profitably. But China’s medium-term prospects are more mixed, so there is no guarantee this success could be repeated.
Observers put responsibility for the near market disaster at the feet of the CSRC, the Chinese securities regulator. The CSRC is among the most junior of market regulators, with an average employee age of 36; department heads earn 10 times less than what they could earn in the private sector.
CSRC clearly calibrated its policy stance badly, triggering an emergency response that went all the way to top levels of the Communist Party. And by adding to the government’s contingent financial liabilities, this could both encourage more serious future crises and damage the government’s ability to respond.
To understand what happened, some background is needed. China’s Shanghai and Shenzhen stock exchanges peaked in June 2015. Their benchmark composite indices had, respectively, risen 150% and 191% in the previous year, in a bull run that saw stocks in favored financial tech and Internet video sectors approach heady three-digit price-to-earnings ratios and new issues leap 10% a day, the maximum allowed, for days on end.
By July the two exchanges’ market values had lost over $3 trillion in market capitalization, or almost one-third of China’s GDP, as their indexes fell 32% and 40%.
The fall in values was only arrested by concerted efforts by all of China’s financial regulatory agencies, the central bank, and finance ministry. And it came at the cost of a market disruption that included suspending 1,442 out of 2,781 listed shares from trading in early July and wide-ranging bans on share sales and short-selling.
Margin Finance to Blame
The tremendous run-up in market values was encouraged by state media and speculation over new merger and acquisition plans for leading state-owned industries. However, the new element was the liberal extension of margin financing.
Margin financing registered with securities brokers hit a peak of 2.27 trillion Chinese yuan (US$373 billion) in mid-June, up from 400 billion yuan in July 2014. To this was added grey-market borrowing to buy stocks with much higher multiples on capital, of up to six times, anecdotally (against a maximum of two times via brokers). The best-informed estimate of this higher-multiple borrowing, far more sensitive to smaller falls, is that it stood at over 2 trillion yuan.
What was initially seen as a sideshow by other policy agencies became a national emergency, raising questions about the Communist Party’s credibility in late June. Banking and insurance regulators joined in, and bans on sales of stocks held indirectly by the finance ministry, 120 state-owned corporations, and all major shareholders, directors, and senior executives came into play. All further new share issues also were banned indefinitely.
By late July the scale of official support was clear with the revelation that state-owned banks had lent the China Securities Finance Corporation (CSF) funds to lend brokers to buy stocks or buy up stocks itself. In all, a massive credit line of up to 4 trillion yuan was made available. To date, state-owned banks made 2 trillion yuan in securities loans, in effect replacing a roughly similar sum of the earlier grey-market margin financing for speculators.
The market has stabilized at above the levels thought likely to force mass selling on the part of margin-financed buyers of shares (thought to be close to 3,200 in the case of the Shanghai market). About 80% of shares were trading again by late July. However, sharp, day-to-day movements in the broad indices of 5%-10% remain plausible.
Damage to Market Credibility
- Regulators have had to make a second, abrupt U-turn on margin finance, one that expands links between the banking system and stocks, and augments moral hazard.
- Share prices have lost what little connection they had to value and company prospects, and will reflect anticipation of policy even more uniformly.
- Investors have reason to fear future sudden repeat freezes of the market.
China’s share market was substantially undervalued, with an average price-to-earnings ratio of under 10, in mid-2014. The stock market should have been a safe way to channel capital into corporations worthy of refinancing as economic growth slowed nationally.
The debacle of a bull market gone wrong will now dog China’s further steps towards capital market liberalization in 2015-16 and spur capital outflows. The postcrash ban on new stock market issues could continue for months, cutting off an avenue for refinancing that the debt-burdened Chinese economy badly needs.
The outsize contribution to economic growth of the financial sector in Q1-Q2 2015 is likely to reverse in Q3-Q4, dragging down output nationally and putting at risk the official 7% growth target for 2015. Waves of selling pressure are likely in late Q4. Once the Shanghai index approaches 4,500, given the six-month ban on sales of corporate and executive shareholdings, brokers can begin selling holdings again.
The official response also suggests that further market declines could have triggered greater risks to China’s entire financial system. For example, bank loans collateralized with shares could have been called. Mass defaults by margin borrowers could have occurred. Though loans collateralized with shares make up only 1% or so of bank loans, nonperforming loan ratios were already growing rapidly. Calling that collateral would not have been welcome. Indeed, the share suspensions of July likely prevented the banks from selling the shares as collateral.
Isaac Leung is a senior economist on D&B’s Global Data, Insight & Analytics team. Based in Marlow/United Kingdom, he covers China, India, and other parts of the Asia/Pacific region as a contributor to D&B Macro Market/Country Insight Products. His areas of interest include maritime economics. He has degrees from Cambridge University and the London School of Economics.