Margin of error

There were signs last weekend that the reverberations in China’s stock market were starting to reach some of the country’s most respected universities.

Confidence boosting was the order of the day, according to an email sent to students before a graduation ceremony at Tsinghua, telling them to “follow the instruction and shout loudly the slogan, ‘Revive the A-shares, benefit the people; revive the A-shares, benefit the people’,” the Financial Times reported.

Later, the university countered that the email was an inside joke and that it hadn’t been approved by the faculty. “Our official slogan is now ‘Actions speak louder than words, shoulder responsibility, be innovative, benefit the people’,” a new text message informed the campus.

The same stipulations might well be directed to China’s stock market regulators, following a brutal few weeks for investors. The situation on Chinese bourses has been bleak, with shares in Shanghai down about a third on their mid-June peak, and the Shenzhen board falling further. More than $3.5 trillion of value has evaporated. The market has since stablised, with the key Shanghai Composite Index hovering around 4,000 this week.

As the smoke clears on the first phase of the crisis, WiC looks at how the government has responded to the wildfires of the last month, before asking what the rescue measures might mean for China’s longer-term policy agenda.

What have the authorities done to stem the rout?

The theme of our Talking Point a couple of issues ago was investor confusion. The market had turned for the worse, but government agencies were sending out seemingly contradictory signals. But as stocks plunged further, the message became more unified.The intervention began with the authorities encouraging people to buy shares, and moved on to ordering others to stop selling them.

The People’s Bank of China had already lowered benchmark interest rates, relaxed reserve requirements for banks and injected liquidity into the market. Then curbs on broker loans were loosened, as the central bank ploughed cash into China Securities Finance Corp, a state-run firm that lends money to people to buy shares on margin. State-owned brokers were pressured to commit publicly to buy stocks until the index rallied. Central Huijin, the controlling shareholder of major state banks, also pledged to raise it stakes in index heavyweights such as ICBC and Bank of China.

The search for culprits – real or imagined – began in earnest. Officials complained market manipulation by foreign investment banks.

The CSRC, the securities regulator, and even the police threatened to hound down “malicious” short-sellers.

Meng Qinfeng, the vice minister of public security, reported that his investigative teams had found early evidence of “trading firms involved in illegal manipulation”.

Meanwhile the IPO window had been closed to stop new shares being issued; while about half the firms on the two main boards in Shanghai and Shenzhen were suspended from trading.

The CSRC has also banned shareholders with stakes of more than 5% from selling for the next six months, threatening punishment for anyone who violates the edict.

The measures stopped the worst of the selling. The Shanghai Composite Index rose from its recent low of 3,507 points last Wednesday to close this Monday at 3,970, up 13.2% over three trading days.

More of the stocks in the trading halt have started to come back on to the market, although 700 were still frozen as of Wednesday. But one of the early outcomes of the suspension was panic selling of shares not embargoed by the regulators, even of better established performers. “Originally, many investors wanted to hold blue chips. But since so many small caps are suspended from trading, the only way to reduce risk exposure is to sell blue chips,” explained Du Changchun, an analyst at Northeast Securities.

To counter this selling pressure, state-owned buyers swung into action, snapping up shares in heavyweights including PetroChina and China Construction Bank, and sending their prices sharply upwards.

Has the government been too heavy-handed?

More seasoned stock-pickers say Beijing has overreacted and that the reversals are a healthy dose of reality for a market that rose more than 150% in the year before the bubble burst. Even after the dramatic falls, share prices are only back to levels set in March.

Other regulators have also intervened in moments of market panic in the past. The Hong Kong government bought shares to fight off short-sellers in 1998, and the Securities and Exchange Commission banned short-selling on some US stocks 10 years later. During the same crisis in 2008, the Bush administration launched its $700 billion asset relief programme, although that was designed to stop companies from going kaput, rather than to rescue an index.

Washington, mind you, took action at a time when a total financial collapse seemed eerily imminent. Comparisons with China today seem stretched in this regard. The growth figure for the second quarter came in this week at 7%, which was ahead of consensus forecasts. Most analysts question whether the share market downturn is going to poison sentiment across the economy at large.

As Qu Hongbin, HSBC’s chief economist for Greater China, has pointed out, less than 15% of Chinese household assets are invested in stocks, and consumption tends to be driven more by income rather than perceptions of overall wealth. “In a nutshell, the wealth effect appears quite hard to pin down, and in any case is very marginal,” he concluded last week.

Fears of financial contagion also look overstated, with few signs of financial stress spilling into other areas of the economy. Money market rates and corporate bond yields have stayed steady, and parts of the property market are even enjoying an upturn.

Some of the dangers may be harder to discern. For instance, Roger Xie, an equity strategist at HSBC, has suggested that the trading halt is buying time for company bosses who had executed stock pledges, which are loans secured against shareholdings in their firms. There was an average of 424 new pledges a month this year, with committed equity reaching about Rmb2.4 trillion of market value.

These company insiders risk having to cough up more collateral for their loans when markets fall, which is why they were desperate to get onto the sidelines during the worst of the rout.

“The A-share trading halt becomes a way to avoid further price declines to lose their stock rights,” Xie explains.

But a longtime reader of WiC made another point by email this week, speculating that many of these pledges could be at risk of imploding, which could then trigger a wider financing crunch. “Much has been written about how small the market is in comparison to China’s economy and how, apart from the hidden shadow banking margin, the spill-over effect of a precipitous fall is quite limited,” the former banker suggests.

“But perhaps the government can see the real level of borrowing by listed companies that is secured against their shares. Perhaps they can see that there is actually a far greater risk of contagion into the mainstream banking sector and this is the reason for their sudden panic.”

This was more about credibility than crisis?

Another interpretation of the government action is that senior figures in Beijing lost their nerve as the markets went into meltdown, fearful of the political repercussions.

The theory is that the central government promoted the rally willingly over the last year, hoping that stronger share markets would help with an overhaul of state-run firms, allowing the more indebted enterprises to refinance with new equity, and thus avoid loan defaults or asset restructurings.

The state newspapers joined the cheerleading effort and millions of investors responded, turning to shares at a time when the property sector wasn’t generating the same returns of a few years ago.

They were helped by rule changes making it easier to borrow for investment, a practice that was banned until five years ago, but which started to boom in earnest from last June. Margin financing tripled to 9% of tradable stock value shortly before the crash, although investors then began unwinding their positions in response to the initial falls in the market. Margin loans from brokerages are said to have fallen significantly from a peak of Rmb2.4 trillion on June 18 to Rmb1.4 trillion at the end of last week.

The regulatory response has been fluid, cracking down on grey market financing but encouraging margin lending from regulated parties. Commentators say that the financial authorities are trying to find a balance between encouraging fund inflows in the short run and promoting deleveraging over the medium term.

“It’s like a flood on the riverbanks,” Zhang Qi, an analyst at Haitong Securities in Shanghai told the Financial Times. “If the water surges to a high level, you can’t channel it away all at once. If the water retreats too fast, it may wash away the lowlands.”

The bull market that started a year ago had been built on the back of Beijing’s policy agenda, which was said to be fostering a new world of economic opportunity. As stock counters ticked higher, they became a barometer for the promise of transformation under Xi Jinping. “The distinctive characteristic of this bull market is not that of a speculative market but rather a confidence market,” the China Securities Journal, an adjunct of Xinhua, advised its readers breezily last year. “The deepening of reforms and the expansion of opening-up has released an enormous dividend that is sufficient to support a long-term, steadily rising bull market.”

That makes it easier to see the recent reverses as a reputational bloody nose for the Xi administration – and certainly the most visible setback so far for a government that has been regarded as much more purposeful than its predecessor, led by Hu Jintao.

“The thing about the stock market is that it’s easy to see,” Patrick Chovanec, chief strategist at Silvercrest Asset Management and an experienced China-watcher, told Vox World last week. “When prices go down, you see them go down. In property and steel and iron ore and shipbuilding and local government debt, you can brush a lot of stuff under the rug and you don’t know what’s going on.”

Despite his styling as a strongman leader, Xi has said nothing in public about the market turmoil. But Russell Leigh Moses, a China-based academic, thinks that Li Keqiang, Xi’s number two, is more likely to be damaged by the slump because he has been more outspoken in calling for faster financial reforms. “While China’s leadership puts a strong emphasis on presenting a united front, the stock market slide could well exacerbate existing policy differences, leaving Li and his allies to explain why the sorts of reforms they have been starting to implement didn’t stave off the recent skid,” he told the Wall Street Journal.

The wider implications of Beijing’s response to the slump?

The bosses at MSCI Emerging Markets Index will feel vindicated after their decision not to incorporate Chinese shares into their global benchmarks just a few weeks earlier.

There will also be questions about the short-term prospects for the Stock Connect scheme, a key reform from Xi’s administration that has offered foreign investors new access to mainland Chinese equities.

The ‘northbound’ channel of Stock Connect – which brings overseas money into Shanghai – has regularly fallen short of its daily quota cap. That hints that international investors were aware of the risks of going long in the Chinese markets. They have also been net sellers of shares via the same scheme for most of the last two weeks. Meanwhile speculation about the debut of a second Stock Connect channel between Hong Kong and Shenzhen’s bourse could well recede in the current climate.

Another bigger-picture question is what the intervention signals for Beijing’s commitments to make its capital account more fully convertible, and for its ambitions for the renminbi to be included in the IMF’s basket of Special Drawing Rights currencies later this year.

This month’s measures fly in the face of much of what has been promised about a more open market, and may prompt a slowdown in the spread of the renminbi internationally. Of course, that will be of little concern to the millions of first-time investors who were still signing up for trading accounts when the stock craze was peaking just a few weeks ago.

According to a widely quoted survey from China’s Southwestern University of Finance and Economics, more than two-thirds of the newcomers hadn’t made it through high school and almost 6% were illiterate. This group will have shouldered some of the worst of the losses and, presumably, those individuals won’t be coming back to the stock markets for a while.

What made this market crisis worse was margin financing – which had been introduced to bring China more into line with global norms. Interest in margin financing had been tepid till the A-share market turned bullish. In those conditions its usage became widespread to leverage up returns. Official data for margin financing volumes rose with each month and by March it had already become obvious to some analysts the danger this could pose. When the market began to fall swiftly, many investors watched in horror as margin financing worked against them and amplified their losses.

Of course, banning margin financing is not the solution. But having learned a bitter lesson in recent weeks, the average Chinese investor may well use margin financing less recklessly from now on.

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