photo: Aaron Goodman
Most things in China are unfamiliar to foreigners, even its stock market. This is the second part of a three part series on the Chinese stock market crash.
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. Overseas investors searched for the next Alibaba, drawn by the prospects of very large gains when that company listed in the US.
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 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) which compares favourably to the 88 million members of its Communist Party. The penetration of and access to the internet and mobile telephony has 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 is no clear single factor that appears to have triggered the price falls. The market simply ran out of momentum and investors lost confidence. The market had become 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. Purchasing new listings increasingly required investors to sell existing investments, creating selling pressure.
The effect of falling prices was amplified by the leverage, in the form of margin loans. The government in conjunction with Chinese exchanges established China Securities Finance Corporation in 2011. It is 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, around 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. There was forced liquidation of positions as investors needed to raise cash or could not meet demands for additional collateral.
All Hands To The Pump
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 SOE may buy back their own shares to support prices. New listings were deferred. With currently planned share offerings of over US$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 US$$2.5 trillion worth of shares or 40 percent of the stock market capitalization.
Eventually, the market stabilised, regaining a part of the fall. The intervention primarily assisted the share prices of big SOEs, such as 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.
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.
Chinese authorities are discovering an old capitalist truth – bubbles are hard to see and even harder to catch.