Yves here. This post, which ran in the second week of July, provides important background on how and why Chinese authorities ramped the stock market, and what the ramifications of the its implosion are likely to be.
By Alicia García-Herrero, Chief Economist for Asia Pacific at NATIXIS, Senior Fellow st Bruegel and non-resident research fellow at Real Instituto El Cano. Originally published at Bruegel
After putting up with a bear market for years, the Chinese stock market started to rally last autumn against the backdrop of a new easing cycle by the People’s Bank of China (PBoC). As if this were not enough in a largely liquidity driven market, the PBoC promoted stock market financing by easing margin credit conditions. As a result, the Shanghai stock market skyrocketed for about nine months until it suddenly moved into red to end up with a huge sell-off, which has wiped out one third of China’s stock market value.
The key questions I will address in this note are why all of this is happening and why we should care.
Why Did We Have a Bull Market to Start With?
The stock market rally was clearly sponsored by the Chinese government. It all started with the widely trumpeted announcement of the Shanghai – Hong Kong Stock Connect last year to help Chinese corporates raise equity beyond the Mainland, with the announcement of a huge number of IPOs following suite. The underlying reason for the Chinese to push the stock market at that time was that Chinese banks and corporations needed a venue to raise equity after an era of excessive leveraging. Yet neither the Shanghai nor the Hong Kong stock market was well placed after years in a bear market.
The need for Chinese corporations and banks to avail themselves of fresh equity cannot be underestimated. On the one hand, corporate debt has grown sixfold from 2005 levels. On the other hand, Chinese banks are not only heavily exposed to these corporates, being still their main source of financing, but also to local governments whose huge borrowing from banks is starting to be restructured. To make a long story short, China’s governments needed a bull stock market to transfer part of the cost of cleaning up its corporates’ and banks’ balance sheets from the state to private investors, including foreigners. The PBoC danced to the Government’s tune, easing monetary policy since November last year. This was done through several interest rate cuts and by lowering the liquidity ratio requirements. The problem with all of this liquidity is that it only fueled additional leveraging, including for gambling on the stock market. The demand for stocks was abundant for two main reasons: the real estate market was no longer a venue for quick gains and shadow banking is less accessible than before – not to talk about the even lower interest rates offered on bank deposits after monetary easing.
The sudden collapse of the Chinese stock market had two triggers. First, the was a wave of profit taking after the Shanghai benchmark index broke through 5 000 in early June and doubts emerged about further easing from the PBoC. At that very same moment, China’s securities regulator announced measures to cool down the market, which amounted to banning brokerage firms from providing unregulated margin funding to investors. This was more of a shock to the system than one might imagine, as margin financing in China is much larger than in other stock markets.
Chinese authorities have clearly been taken off-guard (perhaps they were too concentrated on watching the Greek drama and missed their own) until the situation worsened later last week. They then frantically announced draconian measures to stop the slide. Such measures included trading halts for as much as half of China’s stock market and cancelling all of the IPOs which were in the pipeline. Another important measure was the creation of a Financial Stabilization Fund through which Chinese brokerages would intervene until the Shanghai stock market could regain a level close to one before the sell-off. The latter measure could well be behind the strong gains we have seen in China’s stock market during the last two days.
China is clearly undergoing a systemic event which will have consequences for both China and its partners.
The most immediate effect will be on China’s corporates and banks, who will not be able to access the equity market for quite some time. This might be an urgent problem for those corporations which had relied on IPO plans. Chinese banks will also be affected indirectly in as far as they will need to support Chinese corporates in these difficult times.
Beyond these direct effects, it seems clear that confidence in China is being severely affected by this event. Consumption and private investment will sure be hit by such a spike of uncertainty. Given that the wealth effect is relatively limited in China (households have large savings and are not leveraged), the largest impact will probably be on private investment.
As China’s growth projections are revised downward, others will feel the pinch as well. Commodity markets and stock markets in the rest of Asia have been the first to react but we should see more coming in terms of revised growth projections in the rest of Asia. Once Europe wakes up from the Greek nightmare, corporations heavily exposed to China – of which there are, many especially in Germany – may need to revise their revenue projections and perhaps their investment plans. This argument can also be extended to US corporates exposed to China. The impact has already been seen in global commodity prices. Both oil and metal prices have already been severely affected, and global risk aversion is closely following China’s stock market collapse. On both sides, more price falls could come once analysts start revising projections for the Chinese economy downward.
On this point, it is obviously too early to know what the impact on the economy will be but it is important to realise that, even if the situation stabilises, at least one percentage point will be shaved from China’s growth rate for 2015. The main damage will be to the financial sector, security brokerages and banks. This also could already account for that one percentage reduction in growth this year, or more so if we consider that the booming stock market has added more than half a percentage point to growth in the first quarter of 2015. This is, therefore, just the start, and we should be presuming a larger reduction in GDP growth unless the government implements another massive intervention like the 2008-09 fiscal stimulus package. However, this would only be a short-term relief to China’s long term issues anyway.
However, the most important point is how all of this may affect China’s internal reform process and, thereby, China’s role in the global economy. The drastic measures taken by the Chinese government seem to indicate that financial – and thereby social – stability is more important than pushing further towards a more market-based economy. The pro-market reforms that Xi Jinping announced at the Plenum in November 2013 look far from where we are today. Half of the stock market is out of action and the Chinese authorities – or their allies – are artificially propping up stock market values in order to survive what is not only a stock market collapse but a confidence crisis.