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Chinese Correction or Bubble?

 5 min read / 

The 53% rise of the Shanghai Composite Index (SHCOMP) in the 2014 annual exercise made it the best performing major benchmark index in the world, but a rapid increase in the use of margin finance in the mainland equity markets has brought an onslaught of extreme volatility. Despite a sustained bull run over a long period of time, the current fragile state of China’s stock markets has caused analysts to become increasingly concerned and jittery.

The increase in the role of margin finance — jumping thirtyfold over the past three years in Shanghai — has contributed to the amplifying effect on gains and losses. It is important to highlight the divergence between similar national as well as major benchmark indexes, giving us an idea of how large a market correction could be. This divergence is easily noticeable in Figure 1 when comparing the SHCOMP to the Shenzhen Composite (SZCOMP) and Hang Seng Index (HSI).

Figure 1. Comparison between: SHCOMP (green), SZCOMP (blue) and HSI (red), rebased at 0% a year ago (Source: Yahoo! Finance)

 

Identifying the possible reasons

The China Securities Regulatory Commission may have played a role, having granted initial public offering (IPO) approval to a large number of companies, thereby raising more than double the amount that IPOs did during the same period last year. Investors are prone to pull large sums of money before the new listings, so that they can invest when the funds are unlocked again. This batch of IPO approvals has locked up an estimated 6.7 trillion yuan worth of funds, thus reducing liquidity for a short period of time and therefore placing even more pressure on the markets.

However, on a positive note, analysts have for now discarded the volatility contagion effect feared in Hong Kong during the month of April when the Hong Kong-Shanghai link was enabled. The next round of analysis with respect to the influence Chinese A shares have on Hong Kong H shares will come in September when the much expected Hong Kong-Shenzhen link is activated.

With respect to the leverage obtained by Chinese investors via margin financing, there is consensus that a key factor of this Bull Run has been investors being able to drive-up stock prices by purchasing shares on margin. As shown in Figure 2 by analysts at Macquarie Research, margin trading as a percentage of free float shares — in other words, not locked up by the Chinese government — reached a record earlier this year. Such high figures have never been seen in any other market at any time in history.

 

Figure 2. (Sources: Wind, Bloomberg, Macquarie Research, June 2015)

Another major topic of discussion  are lending rates, with the bulls arguing it is only down to the falling interest rates. However the Chinese central bank has maintained its stance on the matter and cut interest rates  for the fourth time since November. Many economists expect further easing in the near future, and analysts at UBS are far from feeling comfortable after stating:

“Monetary easing will surely give the impression that monetary policy is being used as a direct response to stock market fluctuations. While this belief can help ensure near-term market stability, the impact on longer-term market health is less clear.”

What the market seems to expect

In the last couple of weeks we have seen statements of all possible types of colours, ranging from those being certain we are in the midst of a bubble period to authorities claiming there is no reason to fear the current red figures. To be even more precise, the Chinese regulating body stated:

“Volatility is a normal status of capital markets… After a reasonable analysis of the current market environment, we find the bullish market logic has not changed yet.”

Such statements aim to dismiss doubts of a major market crash, but of all words the most relevant one might be the last one, “yet”. Recently, we have seen a variety of policy moves such as cutting interest rates to record lows, reviewing margin lending rules and agreements of injecting cash into the economy. With respect to IPOs, regulators have noticed the evident need to hand over IPO approval powers to the respective stock authorities. Such swift interventions have so far not had the impact on the market that many anticipated, but have for now put a halt on the frantic analyst outlooks. The majority of analysts have come to conclusions resembling the one stated by Yang Liu, Chairman & CIO of Atlantis Investment Management. She said in an interview:

“If you look at the big picture, there is no reason for the Shanghai Composite not to go higher but before that we need to lay down the foundations… the correction is just part of a new normal.”

In general, having a high stock market is beneficial for the economy and the Chinese government certainly knows that. But as shown in the past week, the market is volatile and not entirely beneficial to authorities that could eventually lose control of a market correction. The regulators’ actions have been closely monitored by jittery investors, and while analysts no longer expect an immediate end to this healthy correction, few are expecting the Chinese markets to roar out of control.

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