News | China’s stockmarket crash

Untameable market

A bad couple of weeks for China's stockmarkets could be felt for years to come

|SHANGHAI

By S.R.

FOR most of the past year, when Chinese stocks seemed capable only of rising, much commentary focused on how the government was in control of the market, pushing and prodding shares into a bull run of epic proportions. A violent correction since the start of June has exposed this view as a fallacy. Regulators have flailed about trying to halt the rout, with little effect. The Shanghai Composite, the country’s main index, has fallen nearly 30% in less than a month. The sell-off of small-cap stocks, which had led the rally, has been even sharper. Chinese regulators may have more levers to pull than their peers in most countries, but even they, it turns out, are powerless to tame the alternation between exuberance and fear that makes stockmarkets yoyo. In fact, their efforts to do so may be exacerbating the volatility.

Last weekend the central bank cut interest rates and freed up extra cash for lenders to dole out. These moves were seen at the time as a ‘PBoC put’—a signal from the People’s Bank of China that it was setting a floor for the fast-falling stockmarket.After three shaky days at the start of the week, though, officials decided to step up their support. The securities regulator relaxed rules on margin financing, making it easier for investors to borrow cash to buy shares and reducing pressure on brokers to call in collateral. The government announced that state pension funds would allocate more cash to the stockmarket. Official media, playing the cheerleader as ever, talked up blue-chip stocks. It did not work: rather than boosting confidence, the series of moves carried a whiff of desperation. The market tumbled nearly 10% on Thursday and Friday.

The crash has underlined the burgeoning role of debt in Chinese share-trading. Goldman Sachs reckons outstanding margin financing, at 2.2 trillion yuan ($355 billion) earlier this week, was the equivalent of 12% of the value of all freely traded shares on the market, or 3.5% of China’s GDP. Both “are easily the highest in the history of global equity markets,” its analysts noted. With Chinese shadow banks and peer-to-peer lenders also offering cash to investors, the amount of hidden leverage in the market is estimated to be as much as 50% higher. That debt helped fuel the initial rally. It is now adding to the pain, as leveraged investors rush to sell their holdings to cover their debts.

This is uncharted territory for China. When its last stock bubble burst, in 2007, authorities had yet to allow margin financing. The presence of so much debt in the market means that the knock-on consequences of the current sell-off could be farther reaching than in 2007. Investors who borrowed to buy shares now face huge losses. Brokers have decent buffers for now after raising plenty of capital, but the current crash will start to wear them thin. Banks, in theory, are immune, in that they are not allowed to lend for stockmarket speculation. But in practice, many will have, whether knowingly or not, and so will have a new category of bad debts to worry about.

Nevertheless, the longer-term consequences of the correction are more worrying than the short-term ones. The capitalisation of China’s stockmarket when judged on a free-float basis is just about 40% of GDP, compared with more than 100% in most developed economies. There has been little evidence of a positive wealth effect (rising share prices leading to more consumption) on the way up, so there should not be much of a squeeze on spending on the way down.

In the longer term, though, the stockmarket is critical to the Chinese economy. After the 2007 crash, investors shied away from shares for years and new listings all but disappeared. A repeat of that would be very damaging for China’s development. For investors from households to pension funds, a well functioning stockmarket is essential given very low interest rates and the shortage of other ways to earn a decent return. For companies, equity financing is needed as a viable alternative to bank borrowing to reduce their reliance on debt. Share listings also demand more transparency and scrutiny of companies, which should improve corporate governance.

The biggest risk, though impossible to quantify, is that the rout will undermine China’s enthusiasm for financial reform. From deregulating interest rates to opening new industries to private companies, the government has vowed to slacken its grip on the economy. But having seen how hard it is to guide the invisible hand, its willingness to let the market play a “decisive role” in the economy, as top leaders pledged in 2013, may diminish. If so, the reverberations of a fearsome fortnight for China’s stockmarket will be felt for years to come.