Chinese volatility has just begun

The Chinese stock exchange curtails free trade and pumps in the cash to get out of trouble.

The figure is significant: $3.9 trillion (€3.55tn). That’s the extent of the losses posted by the Shanghai Stock Exchange Composite Index and its Shenzhen equivalent during the course of the three longest weeks of the Greek crisis. For the sake of comparison with the eurozone, the loss is close to 16 times the Greek GDP. The emergency has been mitigated, primarily thanks to invasive action by Chinese regulators, but it's still too early to say that the worst is behind us. After all, the Shanghai index had grown by more than 80% since the start of the year. The great age of Chinese market volatility is only in its infancy.

While policymakers and financial brokers in Europe shook at the thought of Greece possibly leaving the euro area, the rest of the world was gazing in dismay at Beijing and Shanghai in an attempt to understand how the Chinese stock bubble would pan out. A few figures are useful for attempting to grasp the magnitude of the phenomenon.

Chinese regulators suspended 1400 stocks. In other words, for the next six months (at least, according to HSBC), the company’s shareholders, management and administrators cannot sell any of the company’s stock. Not one iota. Sales have been prohibited in order to avoid new collapses. And operators and regulators have poured liquidity into the exchanges on the order of $19 billion (€17.4bn). Nevertheless, the situation in Hong Kong is still very worrying. At the end of July, the average Chinese share listed on the Shenzhen market was being offered at a 33% discount compared to the Shanghai list price.

As the asset management company Schroders noted, “The Chinese composite index (therefore not just Shanghai, Ed.) has had growth peaks of up to 60% since the start of the year”. International investors clearly found these numbers very tempting given the lack of growth in European financial markets, but they were also a symptom of a blatant imbalance.

The rally that took off last March had all the makings of a bubble: unconnected to macroeconomic fundamentals, much too quick and clearly irrational. After all, as Schroders' emerging markets economist, Craig Botham, pointed out, “the increase in the P/E ratio was hardly justifiable in an economy suffering from excessive production and low demand”. Essentially, the outcome was what everyone feared and, in part, had gone along with.

This was the case for Chinese policymakers who did all they could to promote the stock bubble with a very clear plan in mind.

What is taking place is an obvious redressing of the domestic financial balance on a number of different fronts. Given the high levels of dependence on debt, the Chinese government has been trying for months to reduce the extent of shadow banking. To do so, it has been raising interest rates on the interbank market in order to spur companies towards financing themselves on the stock market.

In other words, it is trying to entice or, better still, steer companies towards launching initial public offerings (IPOs).

At the same time, this rebalancing process is also being carried out on the banking front. The more financial support for recapitalization is sought through stocks, the greater the demand for obligations issued by local administrations. The disintermediation, called for in no uncertain terms by the Beijing authorities, is perhaps taking place too fast. According to Nomura analysts, over the course of the last year 60% of Chinese financial companies have preferred to access credit markets other than traditional banking or alternative options such as shadow banking. This means that, even for the banking industry, financial resources are coming from the corporate market, the stock exchange and local administrations.

And because these markets are still young and have less efficient watchdogs than advanced economies, the risk of imbalances is even greater.

There are also a few factors that at least in the long term could make matters worse. The first is regulatory actions which have introduced restrictions on margin finance, now standing at 3.4% of GDP, as noted by J.P. Morgan. The more the authorities run scared, the more investors will do the same and feed the wave of sales of the various classes of assets involved in the bubble – from stocks to local administration obligations.

The second factor is related to the fundamentals of the Chinese economy, which are clearly getting worse. “We expect China's annual GDP growth to slip below 7% already during this year”, Stanley Morgan warned. At this rate, investors consider the Chinese economy to be in recession. “The risk is a de facto Japanese style stagnation”, according to analysts at the US bank.

And then there's the third factor, the most dangerous one. Bubbles by their very nature are unpredictable. We have seen that with the Dutch Tulipmania, hi-tech shares on the US market and sub-prime mortgages. But the Chinese bubble is different. Firstly, because it has been encouraged partly by the Beijing authorities as a way of redressing the balance of the economy. Secondly, because it involves a wide range of sectors. It's not just the stock market; local administrations, shadow banking and corporate debt are also involved. HSBC views it as “a plethora of bubbles of various entities, none of which should be taken lightly”.

The good thing at least in the medium term is that the Chinese central bank, the People’s Bank of China (PBoC), has plenty of arrows in its quiver with which to reduce volatility. From injections of liquidity to the completion of macroprudential regulation, the PBoC still has a means of stopping the rot, both now and in the future. The problem is that it is not clear how deep China’s imbalances run, and perhaps it will become apparent only when all of the various bubbles burst. 

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