Wednesday, July 8, 2015

The bulls that broke China SHEN HONG, RUCHIR SHARMA THE WALL STREET JOURNALJULY 09, 2015

The bulls that broke China

An investor slumps as the Shanghai index tumbles this week.
An investor slumps as the Shanghai index tumbles this week. Source: AP
The first major sign that all wasn’t going according to script came on June 15. Chinese investors had awakened expecting big gains on the state-sponsored stockmarket because it was President Xi Jinping’s birthday, but the Shanghai market fell more than 2 per cent.
One deeply indebted day trader committed suicide by jumping out of a window, his net worth wiped out by the collapse of a single stock that he had borrowed heavily to purchase.
In most countries, no one thinks there is a link between a leader’s birthday and the market. That such a theory prevails in China reflects the widespread belief that Beijing’s authoritarian government can produce any economic outcome it wants. But now trust in China’s ability to command and control the economy is faltering. If trust finally collapses, the global repercussions could be significantly more severe than those from the Greek debt crisis.
Today the Shanghai index and smaller, more volatile indexes in Shenzhen are off more than 30 per cent from those June highs.
Even after the peak, new investors opened millions of brokerage accounts so they could play the rally. Sophie Wang, a 32-year-old college art teacher in Nanjing, says she opened her first stock trading account two weeks ago and bought some shares on “the advice of my hairdresser”.
Wang says her holdings are now down 32 per cent. “I don’t ­really follow news on stocks that closely. My hairdresser said it was still a bull market and I needed to get in,” she says. She didn’t know what to do when the market started falling and she is still holding her shares.
Others have soured on the market after big losses. Anita Lu, a public relations executive in Shanghai, put most of her savings in a Chengdu-based pipe-maker that trades on China’s small-cap ChiNext market. That was in late May when the stock was at 140 yuan ($30). She sold it last week at 44 yuan.
“I will stay away from stocks as long as I can,” she says.
When China’s economy slowed following the 2008 global financial crisis, Beijing pumped vast amounts of liquidity into the system. First that money went into the property market, later into the various debt-related products sold through the shadow banking system. But when property slumped and the shadow banks started to pose systemic risks, China had only one major market left to flood — stocks.
Funnelling some of China’s $27 trillion in savings into stocks was a last-ditch effort to revive flagging economic growth by giving the country’s debt-laden companies a new source of financing. The aim was to trigger a slow and steady bull run, but the somnolent stockmarket exploded into one of the biggest bubbles in history.
There are four basic signs of a bubble: prices disconnected from underlying economic fundamentals; high levels of debt for stock purchases; overtrading by retail investors; and exorbitant valuations. The Chinese stockmarket is at the extreme end on all four metrics, which is rare.
The sharp equity rally took place despite sputtering economic growth and shrinking profits. By official count, margin debt on the Chinese stockmarket has tripled since June last year. As a share of tradeable stocks, margin debt is now nearly 9 per cent, the highest in any market in history. At the leading brokerages, 80 per cent of margin finance has been going to retail investors, many of them new and inexperienced.
Today China’s 90 million retail investors outnumber the 88 million members of its Communist Party. Two-thirds of new investors lack a high school diploma. In rural villages, farmers have set up mini stock exchanges, and some say they spend more time trading than working in the fields.
The signs of overtrading are hard to exaggerate. The total value of China’s stockmarket is still less than half that of the US market, but the trading volume on many recent days has exceeded that of the rest of the world’s markets combined. Turnover is 10 times the level seen at the peak of the previous China bubble in 2007, and virtually the entire market inventory is changing hands every month. Such frantic activity has pushed up valuations for companies large and small, with the broad CSI 500 index trading at 50 times last year’s earnings and the Nasdaq-style board Chinext valued at 110 times last year’s earnings.
Since the June 12 peak, nearly $4 trillion in value has been erased, as Beijing takes increasingly desperate measures to arrest the price collapse. The authorities have cut interest rates and transaction fees. They have directed mutual funds and state pension funds to buy stocks. This comes when the real cost of corporate borrowing is high. Any further reduction in interest rates could accelerate the outflow of capital, after a record $400 billion has already left China this year.
On Saturday, Beijing took its most decisive action yet, suspending initial public offerings and establishing a market-stabilisation fund to spur stock purchases. The Chinese central bank also pledged to provide funding to support brokerages’ margin finance operations that allow investors to borrow cash to buy stocks.
China has suspended IPOs before in hopes of boosting the market by way of cutting supply. This time, the stakes are higher because an estimated four trillion yuan, almost $900bn, worth of IPOs was in the works, and Beijing had hoped to use a buoyant stockmarket to help heavily indebted companies raise cash.
Investors have looked to Beijing since the start of the rally. In June, a rumour spread among investors that the People’s Bank of China would ease bank lending requirements later that day and the market would rally. When the central bank didn’t act, investors began to sell.
Just as sentiment was starting to turn negative, China’s securities regulator hit the market with a flood of IPOs. The total amount of fundraising from IPOs surged to 61.4 billion yuan in June, up from 17 billion yuan in May and 11.2 billion yuan in January.
Under new rules intended to boost the returns of IPOs, offering prices had been set low, leading to huge price surges in the first days of trading. Investors eager to get into the IPOs sold off shares they already owned ahead of the deals, to pledge cash to brokers in the hope of getting a piece of the IPO.
“There were too many IPOs and it locked up too much money. It was liquidity that made this bull market happen in the first place,” says Yunfeng Wu, an individual investor in Shanghai.
On Thursday, June 18, days after the market peaked, Shanghai-based brokerage Guotai Junan Securities introduced its 30.1 billion yuan IPO, the country’s biggest in five years. “The increased supply of new shares, especially the mega IPOs, was a game changer,” says Chaoping Zhu, a Shanghai economist.
That day, the market fell 3.7 per cent, marking an acceleration of the decline. “When the market fell that day, I thought it was a good opportunity to get in,” says Frank Zhuang, a 43-year-old artist in Nanjing in eastern China.
Zhuang bought 20,000 shares of Guanghui Energy Co at about 12 yuan each. “I thought it was a good bet because the government has repeatedly said it would develop the Xinjiang area further and energy is obviously important to China’s growth,” he says. The Shanghai index fell again the next day, generating a loss of 13.3 per cent for that week, the worst weekly performance for Chinese stocks in more than seven years.
Beijing reacted quickly, with the central bank injecting cash into the financial system. Investors wanted more aggressive action, and the sell-off continued. As stocks fell, investors who borrowed money to buy shares began getting margin calls from brokers, or began selling themselves, fearful of incurring huge losses.
The surge of such margin finance had been a key driver behind the rally. Outstanding mar­gin loans reached a record 2.27 tril­lion yuan as of June 18, before dropping to 1.91 trillion yuan as of Friday, July 3. It stood at 1.03 trillion yuan at the start of this year.
Fears of widespread margin calls led to further selling; China’s more volatile small-company market in Shenzhen had fallen 20 per cent from its peak, marking the threshold for a bear market, and Shanghai was down by 19 per cent since hitting its high. Already, the selling since June 12 had wiped out $1.7 trillion in market capitalisation, an amount almost equal to Australia’s GDP.
On Saturday, June 27, the central bank announced a quarter-point interest rate cut coupled with the loosening of some banks’ reserve requirements, a combination not seen since 2008, at the height of the global financial crisis. The next Monday the market fell another 3.3 per cent, hitting an official bear market. China’s securities regulator tried to calm investors, saying the number of buyers had “notably increased from Friday”. Investors joked that the number of sellers increased even more.
With Guanghui Energy’s share price down by more than 30 per cent, Zhuang, the artist, has given up on the market. “I just sold a painting and got fresh money, but I think I’d better spend it on renovating my studio rather than diving into stocks again,” he says.
Amy Lin, senior analyst at Capital Securities, says the main cause of the sell-off was the earlier gains that “were too fast and too much”. At their respective peaks earlier this year, Shanghai’s market had risen 162 per cent from its low in 2014, while Shenzhen was up 162 per cent and China’s small-company index was up 233 per cent.
“The government probably thought the bull had run too fast, but who would have thought that the bear runs even faster,” says Lin.
The continuing crisis is viewed, locally and globally, as a test of China’s control over the economy. The “Beijing put”— a perception that the Chinese economy and markets are backstopped by the government — is under threat. That perception has underpinned the widespread belief that Chinese growth won’t fall much below 7 per cent because that is the government’s desired target and Beijing is omnipotent.
Looming over all of this is China’s huge run-up in debt, which has increased by more than $US20 trillion — to about 300 per cent of GDP — since the global financial crisis in 2008.
All along, the bulls argued that Beijing had successfully managed every challenge to its three-decade economic boom, and that it could overcome the threat this debt represented.
At a minimum, the argument went, China’s financial woes would be smaller than those of other countries with high levels of borrowing. This faith in Beijing encouraged many global hedge funds to pile into Chinese stocks.
But if Beijing can’t stop the market’s tumble, there could be a sudden shift in the perception of exactly how far economic growth might fall under the weight of too much debt.
If that floor crumbles and the Chinese economy spirals downward, it will make the drama surrounding Greece feel like a sideshow. China has been the largest contributor to global growth this decade; Greece’s economy is about the size of that of Bangladesh or Vietnam.
There is no global drama that bears closer watching than Beijing’s battle for control.
The Wall Street Journal

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