Guest Post: China Is Not What It Seems

Recent Price Movements Not Coinciding with Chinese Economic Growth

On June 12, we saw carnage in the Chinese stock markets. The Shanghai composite has since tumbled in just three weeks, 30% from its seven-year high, wiping out more than $3 trillion worth of wealth.

What is even more curious is the stock market boom starting in June 2014, which saw the index surging up 110% to a seven-year high of 5166 points in June 2015, just before the crash.

 The Shanghai composite and the Shenzhen composite index. Both have entered into bear markets after falling more than 20% since their respective peaks.

The Shanghai composite and the Shenzhen composite index. Both have entered into bear markets after falling more than 20% since their respective peaks.

Does this irrational exuberance in the Chinese stock markets make sense, especially with arguably ugly economic figures? I feel what we are seeing is the cumulative product of the market's irrational exuberance.

 Although China's official (overstated) industrial production figures have somewhat recovered, They remain far below levels justifying a 7% GDP growth.

Although China's official (overstated) industrial production figures have somewhat recovered, They remain far below levels justifying a 7% GDP growth.

The term "irrational exuberance" was famously coined by Alan Greenspan to explain unsustainable investor enthusiasm that drives asset prices up to astronomical levels. Levels that are not supported by fundamentals.

If we look closely at China's manufacturing data shown by industrial production and PMI, it is clear that manufacturing output has been falling over the years which signals an economic slowdown, as manufacturing is one of the core contributors of Chinese GDP.

However, despite fundamental economic data clearly showing weakness in the Chinese economy, it puzzles me as to why the market has failed to react accordingly.

Chinese GDP Growth Of 7% Is Probably Overstated

I believe that the latest Q2 GDP figures published by the Chinese government is probably not an accurate reflection of the actual growth rates in China. Chinese GDP figures and manufacturing levels are most likely overstated. Proof lies in HSBC's manufacturing PMI not coinciding with the official PMI reading.

 China's official (state reported) manufacturing PMI has been under 50 (contraction) for almost all of 2015. July's reading came in at 47.8, the lowest since March 2014.

China's official (state reported) manufacturing PMI has been under 50 (contraction) for almost all of 2015. July's reading came in at 47.8, the lowest since March 2014.

Latest figures reveal that PMI levels are at its lowest, standing at 47.5 which signals sluggish sentiment within the manufacturing sector. The HSBC PMI reflects the sentiment among the small and medium sized enterprises.

This is definitely a better reflection of business sentiment in China because it is well known that larger corporations enjoy state funding from the central government and may not have been as adversely affected by the slowdown, compared to small and medium sized enterprises.

The most likely reason for the recent rally in Chinese stocks despite weakening economic fundamentals might be attributable to the aggressive slashing of interest rates, in conjunction with an unquenchable interest from young Chinese investors.

 The number of individual stock brokerage accounts in China stands at nearly 260 million.  Almost 80% of the Chinese stock market is made up of retail investors. This contrasts to institutional funds making up the majority of developed markets.

The number of individual stock brokerage accounts in China stands at nearly 260 million.

Almost 80% of the Chinese stock market is made up of retail investors. This contrasts to institutional funds making up the majority of developed markets.

This particular demographic has been eager to profit from the bull run. They would rather buy blindly even at elevate prices, rather than missing out entirely - in other words, ephemeral and volatile speculative demand now drives much of the Chinese stock market.

Evidence of this can be seen in the sheer number of brokerage accounts being opened since June 2014. Until the most recent rout, this trend was still skyrocketing.

In fact, the number of accounts opened as of March 2014 was 181.5 million, more than the combined number of Chinese communist party members of 85 million, also eclipsing the total number of institutional investors combined.

The fear of losing out in the great bull run has caused many young Chinese investors to employing excessive leverage. Over the past few months, margin finance has risen from a mere 1 trillion yuan to 1.46 trillion yuan in march 2015. 

And there we have it. The equation explaining the bull run in the Chinese market: Increase in retail investor participation + increase in leveraged stock trading.

 A visual breakdown of retail participation in China's stock markets according to region. East China (Shanghai, Shenzhen, Guangdong) has the highest concentration of retail participation, with Shanghai topping at 10.4% of all A-share brokerage accounts in Greater China.

A visual breakdown of retail participation in China's stock markets according to region. East China (Shanghai, Shenzhen, Guangdong) has the highest concentration of retail participation, with Shanghai topping at 10.4% of all A-share brokerage accounts in Greater China.

More Bad News To Come

 The Chinese central bank, the PBoC, has been aggressively easing since 3Q 2014. They achieve this by cutting both benchmark interest rates and the required reserve ratio (RRR). 

The Chinese central bank, the PBoC, has been aggressively easing since 3Q 2014. They achieve this by cutting both benchmark interest rates and the required reserve ratio (RRR). 

Recently, the Chinese central bank announced that it will be further cutting interest rates to help spur economic activity in order to maintain its economic growth target of 7%. This has however not come without negative consequences such as:

  1. Fueling of unsustainable property prices
  2. Increased Debt to GDP Ratio

Ever since the central bank began cutting interest rates, prices of Tier 1 properties has shot up by 3% MoM, similar to the housing bubble experienced in 2013 before the Chinese government introduced their own property cooling measures. 

What is even scarier is the fact that cheap state-subsidized financing has only resulted in China’s Debt to GDP ratio increasing to its all time high of 208%.

 Luxurious and expensive residential properties (Tier 1) have seen an astronomical growth in their average prices despite property cooling measures having been implemented by the government. It is clear that demand comes from speculative and investment channels.

Luxurious and expensive residential properties (Tier 1) have seen an astronomical growth in their average prices despite property cooling measures having been implemented by the government. It is clear that demand comes from speculative and investment channels.

Half of this debt can be associated to the property market, according to McKinsey & Company. This is in tandem with the sharp increase in Tier 1 property prices. Inflation in property prices can be generally linked to growth in both private and public sector credit.

Furthermore, super cities like Shanghai and Beijing are borrowing at record levels to build public infrastructure, blowing debt levels to approximately 17.9 trillion yuan. This is more than enough to set alarm bells ringing - debt levels are growing faster than China's GDP.

If left unchecked, it is possible that we could see another speculative bubble forming, particularly in Tier 1 cities like Beijing. On a long enough timeline, this could ballon into an unprecedented bubble which would result in an aftermath similar to Japan in 1991, the lost decades in which she suffered painfully up till today.

What Is Next For China

The Chinese government is currently doing whatever they can to advert another stock market crash which would spark massive credit defaults by Chinese investors.

However, the possibility of a meltdown in the Chinese banking sector cannot be ignored due to its elusive shadow banking sector where many trade deals are dealt with behind the scene.

As of now, I believe that the measures put in place by the Chinese government is enough to stop the stock market from plunging to lower levels. However, the risk of a massive credit crisis cannot be ruled out unless the Chinese government cracks down on the shadow banking sector.

Appendix

Contained in this section is content for further reading. They will add color to the picture and fill readers in on some of the points they have not yet been addressed.

1. A secular shakeup beyond the markets

It is reasonable to expect the consequences of this debacle to extend far beyond the financial markets. This was one instance where the market proved that no central government is infallible to the laws of supply, demand, and gravity. Investors' and the market's faith in the CCP's ability to keep the music playing has undeniably been reduced.

 Contagion is well and alive in China. A property bust has caused carnage within the construction industry with demand for commodities such as steel and concrete plunging at rates not seen since the 2007 - 2009 financial crisis. Damage has spread beyond construction to industrial activity, as evidenced by the slump in overall machinery sales, which has also been contracting at rates not seen since 2008.  Charts courtesy of UBS

Contagion is well and alive in China. A property bust has caused carnage within the construction industry with demand for commodities such as steel and concrete plunging at rates not seen since the 2007 - 2009 financial crisis. Damage has spread beyond construction to industrial activity, as evidenced by the slump in overall machinery sales, which has also been contracting at rates not seen since 2008.

Charts courtesy of UBS

More from Bank Of America:

"A dent to market’s faith in government role

We believe that the biggest damage caused by the A-share market’s roller-coaster ride since the middle of last year has been to investors’ faith in the government’s ability to manage asset prices (stock, RMB, debt and even property) reasonably smoothly. The difficulty the government has faced to stabilize the stock market has demonstrated the downside of that faith. As a result, we expect many of these assets to be re-priced lower going forward. Also,the ripple effect from the market correction has yet to show up – we expect slower growth, poorer corporate earnings, and a higher risk of a financial crisis.

Many assets in China may get re-priced lower

We question the implementation of government policy in urging people to buy stocks. Regarding the deleveraging process in the market, in our view the government started too late & without adequate preparation for the potential downside (we suspect because it didn’t know the true extent of shadow margin financing activities) and it resorted to administrative control when the market turned down. So far, government measures have appeared to us to be behind the curve. As a result, we expect investors to assign less value to various perceived government “puts” going forward. The fall in the stock market could also make the government even more cautious towards QE and potentially using the property market or debt market to hold up growth, in our view – a burst of any of these bubbles, if fully developed, will be far more difficult to deal with than what’s happening in the stock market.

Real economy & corporate earnings will suffer

The net result of this volatile market is a transfer of wealth from the people on the street to the wealthy, including many major shareholders, who cashed out. We expect this will likely hurt consumption down the road. More critical is a potential distortion to credit flows due to the impairment to financial institutions’ balance sheets – as experience with Japanese banks shows, even if they don’t have to mark to market and book losses, their lending attitude may turn more cautious. Of course, the impact of a full-blown financial crisis in China, if it materializes, on the economy would likely be severe. On corporate earnings, other than the drag from slower growth, many companies may have to book stock-market related losses over the next few quarters by our assessment.

A possible trigger for a financial crisis in China

If the market continues to fall sharply, stock lending related losses could run into Rmb trillions, of which, banks and brokers may have to bear a meaningful share. These potential losses can be especially dangerous to brokers whose capital base is less than Rmb1tr. Even more important, the opaqueness of China’s financial system and the lack of clear definition of risk responsibility mean that contagion risk is high, similar to the subprime crisis. We had always considered the risk of a financial crisis in China as high. What has happened in the stock market has likely increased the risks considerably and also brought forward the timeline by our assessment – the leverage is much higher now and economic growth rate, potentially lower."

2. Some measures undertaken by the Chinese government during the rout

Outlined below is the chronographic series of measures the Chinese government undertook, perhaps in growing desperation, to stem the selloffs across its markets. The list ends at 7 July but we note that there have been a constant barrage of new measures up till this day. 

 China's market and policy timeline visualized since November 2014 till July 5. Note that this is a truncated view and does not fully cover the expanse of measures carried out by the Chinese government.   Chart courtesy of Bloomberg

China's market and policy timeline visualized since November 2014 till July 5. Note that this is a truncated view and does not fully cover the expanse of measures carried out by the Chinese government. 

Chart courtesy of Bloomberg

More from Bank Of America:

"Taking action to stabilize the A-share market

June 27: RRR cut and rate cut

The People’s Bank of China (PBOC) announced cuts in the benchmark 1-year lending rate of 25bps to 4.85% and the 1-year deposit rate of 25bps to 2.00%, effective June 28, 2015. Meanwhile, the central bank also cut the RRR applied on qualified financial institutions with a focus on rural and/or SMEs loans by 50bps, and that on finance companies by 300bps. This is the first combined interest rate and RRR cut taken during this round of policy easing. Morgan Stanley expects the move to release around Rmb230bn of liquidity into the system.

June 29: Up to 30% of US$570bn pension fund likely to be invested in stock market

“Basic Rules of Pension Insurance Fund Investment Management ” has started to solicit feedback from the public. According to the preliminary draft, up to 30% of the fund could be invested in equities and equity-related investment products.

June 30: 13 major private fund managers jointly voiced bullish views on A shares

Thirteen major China private fund managers jointly announced that the core foundation for the A-share rally has not changed – stable monetary policy, structural reform, asset reallocation by Chinese households. The risk-return profile has improved after the recent correction and provided good investment opportunities for mature, rational investors. The joint announcement was organized by China Asset Management Association.

June 30: Easing of regulations/rules on margin financing

i. On existing margin financing through unofficial channels: CSRC announced that total underground margin financing is estimated to be Rmb500bn. The total amount of mandatory position closing during the previous two weeks was only Rmb15bn.

ii. On regulations/rules regarding margin financing through unofficial channels: CSRC announced that brokerage firms are allowed to provide data feed connection to web-based securities services operated by qualified third parties. Service providers that have been involved in rule-violating activities will need to go through reforms and rectifications. During this period, the service provider can continue providing service for the existing margin balance, but not grow any new business.

iii. On regulations/rules regarding margin financing through brokers: One major Chinese broker, Guo Tai Jun An, announced on its website that it had decided to adjust up the collateral conversion ratio for selective CSI 300 Index constituent companies (equity holdings that could be used as collateral for margin financing) and adjust down margin maintenance requirement, effective starting from July 1.

July 1: Easing of regulations and rules on margin financing

i. CSRC announced new rules on margin financing through a new version of “Brokerage Firm Margin Financing Business Management Rules”.

a) Removes the requirement of margin calls with two business days when investor’s collateral market value falls below 130%, and that total value of collateral (existing + additional) needs to be above 150% of the financing amount.

b) Allows brokerage firms and their clients to decide between themselves the requirement for the deadline and amount for margin calls.

c) Allows more flexibility for brokers to treat investors’ collateral – forced liquidation is not mandatory any more.

d) Brokerage firms are allowed to roll over existing margin financing contracts that are not longer than six months.

ii. The Shanghai Stock Exchange announced that real estate and equity ownership can be used as additional collateral if margin calls get triggered.

July 1: Increase of shareholding by listed companies

i. Increase of shareholding by major shareholders: Between June 15 and July 4, major shareholders of 182 A-share listed companies have increased their shareholding through secondary market purchase. There were more 20 listed companies announcing shareholding increases on July 3.

ii. Shares repurchase by A-share listed companies: China Vanke A (000002.SZ), TCL Corporation (000100.SH), Media Group (000333.SZ), BOE Technology (000725.SH), Bright Oceans Inter-Telecom Co Ltd (600289.SH)

July 2: Reduction of equity trading transaction fee

The Shanghai Stock Exchange, Shenzhen Stock Exchange, and China Securities Depository and Clearing Corporation Ltd announced reductions to A-share trading transaction fees: from 0.03% of transaction face value to 0.002% for Shanghai Stock Exchange, from 0.00255% to 0.002% for Shenzhen Stock Exchange, effective from August 1.

July 3: China Securities Finance Corp Ltd (CSFC) capital increase and share expansion

CSRC announced that CSFC will expand its registered capital from Rmb24bn to Rmb100bn. CSFC will raise funding from multiple channels in addition to stabilize capital market.

* CSFC was founded in 2011 under the context of beginning of margin financing business in China. It is the only investment business entity in China that has been approved to practice margin refinancing. Its business is mainly focuses on: 1) raise financing to lend to brokers for their margin financing business; 2) provide a platform for insurance companies, mutual funds, strategic shareholders of listed companies to lend out their equity holdings.

CSFC's major shareholders include: Shanghai and Shenzhen stock exchanges, China clearing, CFFEX, Dalian Commodity Exchange and Zhengzhou Commodity Exchange. Besides the refinancing business, it also tracks and monitors the overall margin financing business in China, analyzes market and credit risks, etc.

July 3: Reduction of IPOs in terms of both numbers and the amount of capital raised

CSRC announced at its press conference that the number of IPOs and the amount of capital to be raised through IPOs will be significantly reduced subsequently.

July 4: 28 approved IPOs got suspended

Twenty-eight approved IPOs that have been scheduled for subscription in July will be suspended. Subscription fund is returned to investors’ investment accounts on July 6.

July 4: 21 major Chinese brokerage firms to invest Rmb120bn in blue chip ETFs

Twenty-one major brokers announced that they will jointly offer minimum Rmb120bn to buy blue chip ETFs. These companies promised not to sell their positions as long as the SH Composite Index is below 4500.

July 4: 25 major Chinese mutual funds to invest in equity funds managed by themselves

Twenty-five mutual funds jointly announced:

1) Chairmen and general managers of these funds promised to actively purchase equity funds managed by their own companies and hold shares for at least one year.

2) Re-open funds whose subscription has been closed to offer investors more investment options

3) Expedite equity funds’ application and distribution, and build positions with newly raised funds according to the funds’ mandates.

* China Asset Management Association announced that by July 6 2015 57 mutual funds are reported to have committed Rmb2.2bn to equity funds managed by themselves. in total 62 mutual funds (including the 25 ones mentioned above) have made public announcements supporting the 25 mutual funds' proposal.

July 5: China HUIJIN's investment in A-share ETFs

China Central HUIJIN Investment Company announced on its website that it has been purchasing open-end A-share ETF index funds on the secondary market, and that it will continue relevant market operations.

July 5th : CSRC announcement of tighter measures against market manipulation and rumor distribution activities

CSRC announced at its press conference that:

i. Plans for upcoming IPOs: There will be no new IPOs in the near term after the 28 approval IPOs got postponed. Processing of new IPOs will not stop; however, the number of new IPOs and the capital to be raised through these IPOs will be reduced significantly.

ii. Actions against shorting index future: CFFEX (China Financial Futures Exchange Inc) has restricted opening positions on CSI500 Index future contracts for some investment accounts. CSRC has required CFFEX to strengthen its inspection actions and coverage to collaborate with CSRC on illegal transactions and market manipulating trading activities.

iii. Actions against rumors: CSRC has initiated securities law targeted law enforcement actions against creating and distributing stock market rumors.

July 5: China Securities Finance Corp Ltd (CSFC) to stabilize the market with liquidity support from PBOC

CSRC announced that China Securities Finance Corp Ltd (CSFC) will raise funding through multiple channels and play an active role trying to stabilizing the market. PBOC will provide liquidity support for this purpose.

* There is no specific limit attached to the liquidity support mentioned in CSRC’s announcement.

July 6: CSI500 Index Future to have trading limit of 1200 lots

China Financial Futures Exchange (CFFEX) announced a daily trading limit for CSI 500 index future (IC500), effective on July 7 2015. Investors can only buy up to 1,200 lots of CSI 500 index future contract for either long or short positions."

3. Retail speculation is retreating post crisis

 Many of the retail stock brokerage accounts in China are heavily funded by margin debt, which has historically been tightly correlated with stock prices themselves. In this case, we believe that correlation is causation - since retail trading makes up 80% of the local markets.  Chart courtesy of Zero Hedge

Many of the retail stock brokerage accounts in China are heavily funded by margin debt, which has historically been tightly correlated with stock prices themselves. In this case, we believe that correlation is causation - since retail trading makes up 80% of the local markets.

Chart courtesy of Zero Hedge

The postmortem of China's stock market rout is now met with a massive scaling back of retail speculation. This is evidenced by the mass closures of previously active stock brokerage accounts.

More from the WSJ:

"Nearly a third of the country’s individual investors—more than 20 million people—fled the plunging stock markets last month.

The number of retail investors holding stocks in their accounts slid to 51 million at the end of July from 75 million at the end of June, according to China Securities Depository & Clearing Corp., the government agency that tracks accounts."


About The Author

  Loh Yuan Bin is a Research Director (executive) of Fundamental Analysis at the SMU EYE Investment Club. He is an undergraduate at the Singapore Management University (SMU), pursuing a degree in Accountancy.

Loh Yuan Bin is a Research Director (executive) of Fundamental Analysis at the SMU EYE Investment Club. He is an undergraduate at the Singapore Management University (SMU), pursuing a degree in Accountancy.

Loh Yuan Bin is a Research Director (executive) of Fundamental Analysis at the SMU EYE Investment Club. He is an undergraduate at the Singapore Management University (SMU), pursuing a degree in Accountancy. Driven by an intense passion for investing, he wishes to promote financial literacy and investing principals amongst the public.

The author was featured in the Invest column of The Straits Times, Singapore's largest newspaper. 

Yuan Bin is invested in the Singapore markets and practices the values preached Benjamin Graham, widely held as the father of Value Investing. He stronglybelieves in the philosophy of this approach to the markets.

His approach utilizes both qualitative and quantitative methods to seek out what he believes is the intrinsic value of companies he analyzes, with the goal of identifying underpriced securities that trade at a discount to fundamental valuations.