The collapse of the Chinese equity market could have revived memories of the 1929 Wall Street market crash.
Nesbert Ruwo and Jotham Makarudze
The wealth of Americans simply disappeared when the market crashed and this was a part trigger of the Great Depression, the 20th century world’s longest and deepest global recession.
Chinese equity market is composed of three stock exchanges — the mainland Shanghai and Shenzhen stock exchanges, and Hong Kong’s Hang Seng stock exchange. The World Federation of Exchanges valued the Chinese mainland equity market at just over $10 trillion (Shanghai $5,9 trillion and Shenzhen at $4,4 trillion) at end of May 2015. Hang Seng had a valuation of $3,9 trillion.
World Bank measures China (2014) GDP in current US$ at $10,36 trillion.
The Chinese mainland market more than doubled over the past year, returning 159% from beginning of July 2014 to its peak on June 12 2015. Subsequent to that, the market lost almost a third of its peak value in less than 30 days. More than US$3 trillion in value was wiped away in that sell-off. Even after this dramatic fall, the Shanghai and Shenzhen composites still show an impressive return of at least 90% each in one year.
The strong run has been supported by Chinese government interest rate cuts, financial reforms which facilitated easier equities trading between the Shanghai and Hong Kong markets and allowed margin trading coupled with double digit economic growth and growing individual discretionary income.
China’s economy has experienced decades of impressive economic growth on the back of massive industrialisation and urbanisation. China has been the world’s fastest-growing economy for almost three decades, achieving growth rates of almost 10% annually. The trend is however showing signs of cooling off to sub-double digit growth rate. China is targeting growth of about 7% for 2015, which remains rich given the size of the Chinese economy.
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China’s mainland stock markets were a preserve only for Chinese investors until recent government reforms allowed limited foreign investor participation. As part of President Xi Jinping’s market reforms, a major capital liberalisation reform in the form of the Shanghai-Hong Kong Stock Connect programme — launched last November — allowed investors in either of the two markets to buy shares in the other market without prior approval.
Thus foreign investors with Hong Kong brokerage accounts could access Shanghai listed entities which sent the Shanghai shares north as international capital coupled with local money piled into the market. The Shenzhen-Hong Kong Connect is still on the cards. As such, only a few foreign fund managers can trade in the Shenzhen market.
Unfortunately, a majority of individual investors were driven by what the former US Fed chair, Alan Greenspan, termed irrational exuberance and drove the Chinese stock market into an overbought territory. Most companies listed on the Shenzhen are trading at price earnings multiples of at least 100 times, and dozens of these are trading at over a thousand times P/E multiples.
It is estimated that over 90 million individual investors have been playing the market. The impressive returns and limited investment options drove individuals to dump in their savings into the market, in a typical herding behaviour. Research reports show that margin trading, that is buying shares using borrowed money, increased dramatically (at least five fold by some measures) over the past year. High volume of margin trading is in itself an indicator of stock market risk.
When the house of cards came crumbling down, potentially exposing millions of investors, and threatening the perception towards President Xi Jinping’s free market reforms, the government unveiled a number of interventions to prepare the market for a soft landing. These included suspension of trading of shares of nearly half of the listed companies, restricting short selling, halting on new listings which was aimed at redirecting new money into existing listed shares, and lending 260 billion yuan (about $42 billion) to brokerage firms to purchase stocks. These interventions supported a short-term rally as the main indices recovered. The biggest question is whether the price rally will be sustained once the interventions are pulled off. Our view is that the interventions will only delay the exposition of the Chinese stock market underlying risks.
An important implication of these interventions is that it has damaged the reputation of the Chinese authorities with respect to their efforts to bring about market reforms. The reforms have taken the form of interest rate and capital accounts liberalisation meant to underpin the Renminbi (China’s currency) into a free tradeable international reserve currency. In the eyes of international investors, the economy is still state dominated and the reforms are a long way to come.
Could a serious financial crisis be brewing in China? Some parallels can be drawn between this crash and that of the Wall Street in 1929. The US market, then, is said to have been fuelled by an influx of the financially “unsophisticated” investors who saw the soaring market as an opportunity to make quick investment returns. The US market lost 89% from its peak and interventions by major banks then failed to floor the crash.
While wanting to embrace free market forces, the Chinese government was forced to take seemingly free market-negating interventions than watch market forces bring about valuation correction of the Chinese market. In the short term, the correction is and will be painful, but as more Chinese households and foreign investors participate on the Chinese market, the long term could be positive for the market.
Nesbert Ruwo (CFA) and Jotham Makarudze (CFA) are investment professionals based in South Africa. They can be contacted on [email protected]
