AFTER taking a beating for the better part of a month, China’s stock market recovered slightly to end the week. But the gains of Thursday and Friday were a classic “dead cat bounce;” the headache the market has caused for the Chinese economy is far from over.
As a clarifying point, “stock market” as I use it here refers to the Shanghai and Shenzhen exchanges and the 12 different indexes which track Chinese stocks in the aggregate, because it’s easier that way, and there are no significant differences in behavior from one index to another.
From July of last year through June 12 this year, when the Shanghai Composite Index reached its high-water mark, Chinese stocks rocketed upward, gaining 150 percent in less than a year. The reason this happened, in the simplest terms in which it can be explained, is that the government in Beijing encouraged it.
As the Chinese economy began to slow – and we must keep in mind that ‘slow’ is a highly relative term when applied to China, a growth rate in the neighborhood of 7 percent instead of a stratospheric 10 percent – the central government began to exert greater efforts to strengthen the domestic economy. One track of this drive was to attract bigger investment in the country’s financial markets; moves such as interest rate cuts by the People’s Bank of China (a quarter-percent on February 28 and again on May 10), reductions in banks’ reserve ratio requirements (half a percent on February 4, and a full percentage point reduction on April 19), and the linkage of the Hong Kong and Shanghai stock exchanges all supported this objective.
And it worked; new investment poured into the market, and they were from just the sort of investors Beijing was looking for – about 85 percent of the market is made up of small, individual retail investors. The enthusiasm drove stock prices higher, encouraged a large number of IPOs and secondary issuances by existing companies, and altogether appeared to validate the policies of President Xi Jinping and Premier Li Keqiang, who have vowed to let market forces play a greater role in the overall economy.
Of course, the typical retail investor usually does not have a substantial stake with which to venture into the market, and so the vast majority of China’s small investors (Bloomberg estimates there are about 90 million of them) bought on credit. The growing leverage was not seen as a real problem by banks and other lenders so long as stock prices were soaring, and of course, the easing by the central bank only helped to make more credit available.
That created a bubble so obvious that even analysts who routinely deny bubbles exist were becoming a little nervous – stock prices inflated not by sound economic or company fundamentals, but by hyperactive trading. All it would take to make the whole thing crumble would be a lower-than-expected economic indicator (such as manufacturing output or exports, both of which took a bit of a downturn), a few companies reporting lower profits, and a few investors to sell in a panic.
Where Beijing got it wrong with the stock market is in focusing too much on the supply side. Investment opportunities for the domestic market were greatly expanded, but little to no attention was paid to whether or not those investors should be encouraged. An indication that at least some of them should not have been was released on March 31 in the form of the China Household Finance Survey, which showed that the typical ‘rally’ investor in the Shanghai market (i.e., those who invested since the second quarter of 2014) wasn’t even a high school graduate.
For all the trouble China has appeared to get itself into with its stock market, the impact on the wider Chinese economy and on economies like the Philippines will probably not be significant. As Dr. Lei Mao, an associate professor of finance at the University of Warwick (UK) pointed out in an email response to some questions about the current crisis, equities are less important to the Chinese economy than they may appear at first, primarily because most private-sector investment is still funded through bank financing. In addition, strict capital inflow-outflow controls prevent China’s problem from spilling over into other markets, except Hong Kong.
Even so, Dr. Mao says, the ‘hangover’ in China is likely to last for an extended period of time as deleveraging of the market proceeds. While it does not appear now that it will adversely affect domestic demand in China (something that would have an impact on countries like the Philippines), the situation could take a change for the worse. Either way, it presents a thorny problem for the Xi government, one that will bear careful observation in the coming months.