The Chinese economy expanded at its slowest rate in 24 years in 2014, yet global investors continue to wonder how long the current equities bull market will last. The CSI 300 Index, an index of the biggest mainland stocks, has increased by 128% over the past 12 months, before having substantial write downs this week, however it does indeed beg the question as to what caused the bull market in the first place.
As recently as 2006, China experienced a short stock bubble that crashed in 2007. However, a key difference between then and now is the introduction of margin financing. Margin financing enables investors borrow from brokers and put up extra collateral if the price moves against them. The outstanding volume for margin financing has doubled over the past 12 months to $300billion. If the high margin lending continues it would mean that any future rallies would be more sensitive to shocks. Stronger shocks will mean investors hit by losses could be forced to sell any shares they hold in order to cover demands for more capital from their broker. This set of events would mean that any downswing would be further exaggerated. Previous examples of crashes that involved high margin lending include the Taiwan and Japanese bull markets in the 1980’s, however the past cannot be used as a reliable predictor of the future because each economy in question is structurally different.
Reasons for the increase in margin financing include an increase in the supply of credit and strong demand from retail investors who are looking for alternatives to property market investments and low-yielding bank savings accounts. Brokerage firms have kept up with increased investor demand for credit by both raising money privately and on the Hong Kong stock exchange. Recent public offerings of securities firms such as GF Securities Co raised $3.6 billion in April.
There has been a sizeable increase in the number of new trading accounts that have opened over the past year. Close to 8 million accounts were opened in Q1 of 2015. Securities firms such as Tebon Securities have only in recent months raised the amount of cash clients need to deposit and reduced the amount of securities clients can use as collateral for margin trading and short selling.
Expansionary monetary policy
China’s central bank has responded to the slowing down of the economy by lowering the amount of cash that banks are required to keep on reserve by 1% to 18.5%. This move has meant a boost for the economy as it has freed up more money for banks to lend. The People’s Bank of China (PBOC) has also cut interest rates to 5.1%, the third cut in the last 6 months, another potential trigger for investors to move into the equity market; as returns on bank deposits continue to fall.
Investors and economists expect the PBOC to continue to implement further interest rate and reserve requirement ratio cuts again before the end of the year. The intentions of the moves were to help stimulate the economy. However, it seems that it has done more to help the market rally.
Housing bubble collapse
Last year saw a 4.5% drop in house prices and this could have potentially triggered investors to move their funds into the equity market in an attempt to achieve higher returns. In the past people have invested their excess savings into the real estate market. This has therefore caused bubble-esque price increases such as the Shanghai real estate market rising by 650% since the year 2000.
Hong Kong- Shanghai connect
The scheme was designed to relax restrictions that have in the past split the Chinese stock market between shares that are targeted at local investors and those available to international investors. Investors in Mainland China can now purchase eligible shares listed on the Hong Kong Stock Exchange via their own local broker. Whereas, Hong Kong and international investors will be able to purchase eligible Shanghai-listed shares through their local broker as well. This scheme has meant further liquidity being pumped into the mainland markets. However, as noted by Manishi Raychaudhuri of BNP Paribas, the Hong Kong- Shanghai connect has contributed a small fraction of the current daily turnover.
What does the future hold?
With China’s capital markets still developing, they make up roughly 44% of GDP, therefore any crash would have a smaller effect on the economy; than say compared to the US, where market cap is 144% of GDP.
Only time will tell whether the government decides to implement further measures to curb the volatility of the market. One thing is for certain maintaining confidence in the economy remains paramount on the agenda; therefore any collapse in the stock market will not help the government achieve this goal.