Chinese Equities: What Goes Up Must Come Down
It should not come as a great surprise that China’s two major stock market indices have nosedived by a third or more since mid-June after more than doubling in the previous 12 months. A relaxation of regulations by the government as well as a wink and a nod signaling that it was alright to move heavily into equities amid sputtering real estate markets helped to fuel the meteoric rise in prices. Given that retail investors own roughly 90 percent of shares in Chinese markets, it is understandable that momentum carried valuations to such heights and reversed as investors rushed to deleverage their positions. During the rally, margin debt surged more than fivefold.
Chinese officials are now scrambling to prevent a complete meltdown in stocks. In their latest action, securities regulators banned major shareholders, corporate executives, and directors from selling stakes in listed companies for six months. Investors with stakes exceeding 5 percent of shares in a company must maintain their positions. Regulators have unveiled measures to try to stem the market rout almost every day for the past 10 days. The China Financial Futures Exchange has raised margin requirements for short positions in CSI 500 index futures, similar to actions taken by U.S. regulators in the aftermath of the financial crisis, when shorting stocks became practically illegal. In addition, it appears that China Securities Finance Corp. is prepared to buy small and mid-sized company stocks, deploying resources that exceed $80 billion.
Although it is unclear when China’s equity markets will reach bottom, it is probably safe to say that if markets stay near current levels, the impact on the national economy would be relatively limited. Despite the fact that 24 trillion yuan, or about $4 trillion, has been subtracted from capitalization in less than a month, investors are still significantly ahead of where they were a year ago. Moreover, Chinese households still probably hold the largest portion of their financial wealth in the form of bank deposits. Data from 2013, the latest available, show that equities accounted for less than 10 percent of household financial assets, though that certainly rose while the market was spiking. During earlier stock market travails, household consumption seemed to be little affected.
The impact on investment spending is also likely to be relatively muted, despite the implied rise in the cost of capital for Chinese businesses. According to data from the International Monetary Fund and Bloomberg, the equity market in China is small (less than 15 percent) relative to the overall financial system. In the United States, the equity market is equivalent to about one-third of the financial system. The easing of monetary policy in China since the final months of 2014 should help cushion any negative impact on investment spending. Further interest rate cuts seem likely as a precautionary measure.
One concern worth noting is the possibility that Chinese authorities have been shaken up enough to slow or even defer their structural reform efforts. These reforms, which are designed to reorient the economy away from its heavy reliance on investment toward consumption of goods and services, have been viewed in some circles as potentially constraining economic growth and increasing the risk of social instability. For a country that has long sought stability, the thought of losing it in the face of bold, yet delicate, moves to weed out corruption and intransigent special interests could give the leadership pause about proceeding with its program.