The recent collapse in the Chinese share market was preceded by a boom – a boom that was, in turn, fuelled by relaxed restrictions on margin lending, and a growth in the shadow banking sector. Both served as inducements for Chinese retail investors to borrow in order to invest in a rising stock market.
The central bank urged people to buy local stocks, cut interest rates, and reduced the required reserve ratio for banks to free up more funds for lending. What could go wrong!
Since late 2013, Chinese authorities have pursued a policy of further opening up the capital markets. The aim has been to “internationalise” the local currency, the yuan (renminbi or “people’s money”), and to link the local stock exchanges to international markets. A major milestone was reached when the Shanghai-Hong Kong Stock Connect (also known as the “Through Train”) was launched in November 2014. This scheme now allows Hong Kong investors to trade on the Shanghai Stock Exchange, and provides a channel for mainland capital into the Hong Kong Exchanges and Clearing (HKEx) - further increasing the internationalisation of Chinese outbound investment.
The Chinese share markets (China has two national bourses, one in Shanghai and one in Shenzhen) are dominated by retail investment, and its 90 million retail investors have fuelled much of the growth.
Given the youth of the Chinese markets (born in 1990), Chinese retail investors are, by definition, inexperienced and prone, like any adolescent, to bouts of exuberance. Along with the stock market boom, even more rapid rises in the value of the two exchanges have been driven by government measures aimed at encouraging money out of the over-heated property markets and into corporate equity.
The property bubble which has hit many Chinese cities has been worrying the authorities since at least 2010, and efforts have been made to crack down on property speculation and investment-driven demand. Home purchase restrictions where first put into place in 2010, and in March 2013 Beijing called for stricter enforcement of a 20% capital gains tax on home sale profits. It also asked cities with fast property price increases to raise the down payment requirement and mortgage rate on second homes.
Damping down the property market is one part of China’s longer-term strategy to move away from its old model of high and increasing levels of investment, especially in industrial activity and urban infrastructure. The new model is based on lower investment, more subdued (more sustainable) growth and higher domestic consumption more in line with shifting national priorities towards improving the quality of air, water and living standards for more Chinese people.
By June last year analysts were warning that investor confidence in the domestic Chinese A-share market (A-shares are denominated in renminbi, B-shares in foreign currency) had been “weak for quite some time”. So when the Chinese banking authorities cracked down on margin lending in June, and the banks began to call in their margin loans, already fragile investor confidence collapsed quickly - and the market fell with it. Those falls continued this week, despite moves by Chinese authorities to restore confidence.
The Chinese authorities have reacted instinctively – the same way that authoritarian regimes everywhere react. They sought to rectify. Rectification in this case has been very restrained by Chinese standards, but even restrained intervention has meant the introduction of a slew of measures aimed at halting the free fall and stabilising the market. These have included temporary halts on trading on over half of all China-listed stocks, a six-month ban on major shareholders selling listed stocks, postponement of approved new listings (IPOs - initial public offerings) and suspension of new IPO approvals.
The authorities also ordered major brokerages to increase their investments and further cut interest rates. The People’s Bank of China even announced it would provide liquidity support to the China Security Finance Corporation, which oversees the margin financing of brokers.
As Robert Shiller explained in 2000, well before the global financial crisis, all markets experience periods of irrational exuberance. Nor should it surprise anyone that a market as young and uneducated as the Chinese market should be more volatile that most.
The real question now is what effect recent stock market volatility will have on the “real” Chinese economy. The first point here is that the Chinese stock index is not closely linked with the macro economy and is not an indicator for economic trends. Second, most financing does not come from the stock market, but from bank loans. Of total social financing in 2014, only 2.6% came from the stock market, while bank loans accounted for 59%.
As the Chinese share markets stabilise around a new lower level, if the money lost from the market goes into real consumption, that could potentially even be good for the economy.
If money lost from the markets simply vaporises in the form of bad loans, gambling losses and corrupt payments, then that will be a significant loss, but one which an economy the size of China’s can bear. The net result, as often occurs with such events, will probably be a transfer of wealth from ordinary Chinese to the wealthy, including many major shareholders who have cashed out.
Ambitious plans for full yuan convertibility under the capital account will probably be delayed as the Chinese authorities become more cautious in their approach. In the longer term, the Chinese authorities, at the very least, will need to establish clearer measures for risk evaluation and responsibility, and begin to educate retail investors.