What went wrong with China’s market

Li-Gang Liu

Former Chief Economist Greater China, ANZ

Investor confidence is tumbling in China and with it the county’s share prices driven by what has been in our view a rapid deleveraging process. The saga, which has seen billions of yuan wiped off the market, provides participants and regulators with an invaluable lesson on risk and rational investing.

Shanghai’s A-share Index has tumbled over 30 per cent from its peak of 5,411 on June 12 to a close at 3,675 on July 8. The past few days have been loaded with news headlines citing various rescue measures and industry’s efforts to shore up confidence.

" The market correction is timely and healthy, allowing share prices to return to a level reflecting their underlying values."
Li-Gang Liu, ANZ Chief Economist, Greater China

Perhaps the most important one was that the China Securities Regulatory Commission (CSRC) announcement the People’s Bank of China (PBoC) would provide liquidity support to a state-run securities company that offer margin trading services.

The collapse of the equity bubble has confirmed the observation we pointed out in April that the credit-fuelled surge in share prices did not have fundamental support and a change in sentiment could bring a sharp fall.

Click image to zoom Tap image to zoom

Indeed, the stock market rally that began in the fourth quarter last year has been underpinned by margin financing. Meanwhile, growth momentum of Chinese economy remains sluggish.

Corporate profitability and even liquidity conditions have been under severe pressure. Many investors entering the market seem to have believed in the “reform bull” theme, a terminology frequently cited in local media.

The share-price plummet has been driven by the rapid deleveraging process, precipitated by allowing shorts in the futures market. The market correction is timely and healthy, allowing share prices to return to a level reflecting their underlying values. In addition, it offers market participants and regulators an invaluable lesson on risk and rational investing.

Not quite a systemic crisis

The rout has yet to become a systemic crisis. Overall, the balance sheet of China’s banking sector remains healthy. The increase in margin trading accounts has been primarily retail based.

There is no evidence that banks have widely accepted equity-based assets held by corporate as collateral, suggesting that falling share prices will unlikely result in massive credit defaults.

Although key stakeholders, i.e. household and institutional investors as well as securities industries, will inevitably suffer from the fall of share prices, China’s financial stability likely remains intact.

While Chinese media predominantly have called the government to ‘save the market’, we believe that such an attempt will only be more harmful. Any action could exacerbate the moral hazard problem and motivate more risk taking at the expense of tax payers and public coffers.

We do not think that the decline in share prices will heavily drag on growth in China. When the market rallied early this the ANZ-Roy Morgan Consumer Confidence Survey did not pick up. Growth momentum has trended down in the first five months, de-coupled from the buoyant stock market rally.

We maintain our 2015 GDP forecast of 6.8 per cent even if China’s stock prices return to the level prior to the rally began in November 2014.

The sharp correction of the equity market leaves big room for the Chinese central bank to ease monetary policy. We expect the PBoC to cut benchmark interest rate by another 25 basis points and its reserve requirement ratio (RRR) by additional 100bps before the end of 2015.

Other than the accommodative monetary policy, fiscal policy is also needed to take a driving seat to boost growth momentum. Urbanisation and the belt-and-road initiative should require plentiful fixed asset investments.

It is hoped that a recovery in China’s real economy in the third and fourth quarters could provide real support to shore up confidence on China’s share market.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.