China: Stock meltdown prompts market intervention

By:
Elliot Wilson
Published on:

Foreign investors pull Rmb40.5 billion in two weeks; average P/E ratio still 66 times.

China’s political leaders took fright at a collapse in the value of mainland-listed equities in early July, introducing a raft of tough new measures to support domestic stock markets. 

Retail investors, who comprise four-fifths of the country’s $6.6 trillion equity market, celebrated as stocks, having soared then swooned, regained their footing. But critics warned that Beijing’s in terventionist tactics undermined efforts to reform a sclerotic financial system, restructure an unbalanced economy, and internationalise the country’s currency, the renminbi.

To many, the recent surge in valuations on China’s two main bourses in Shanghai and Shenzhen came as little surprise. Beijing’s decision last year to approve margin trading was a tacit nod of approval to onshore investors, who ploughed into mainland shares.

xi-jinping-160
President Xi Jinping (l) and his premier, Li Keqiang, had made much of their reformist credentials

The Shanghai Composite index doubled in value in just seven months, topping 5,160 points on June 16. It was neither a record high nor the fastest acceleration in mainland stocks: that record was set in 2007 when the index tripled in value in nine months, briefly topping 6,000 points. Then, the state acted calmly after the bubble burst, allowing prices to self-correct. 

Chinese president Xi Jinping and his premier, Li Keqiang, had made much of their reformist credentials. Both talked up the importance of shaking up state-run banks and firms and of rebalancing an export-heavy economy. Yet they also led the charge for higher valuations, filling a compliant media with tales of the riches to be made from stock speculation. To some, this was a ruse to paper over the cracks in (and divert an increasingly fretful populace’s attention from) a slowly peeling economy on track to grow by less than 7% for the first time in 15 years.

Panic

So when the Shenzhen market slumped 40% in just three weeks from June 12, with the Shanghai Composite tumbling 32%, wiping $3 trillion off the value of stocks, Beijing "seemed to panic", says Francis Cheung, head of China-Hong Kong strategy at brokerage Citic CLSA. 

Fraser Howie, co-author of 'Privatizing China’ and 'Red capitalism’, adds: "The Xi government was the market’s cheerleader on the way up, but got spooked on the way down when they realised the boom was financed by margin and credit." 

Victor Shih, a China expert at the University of California in San Diego, saw the sell-off as the "largest challenge" yet faced by the three-year-old Xi-Li administration. For a full week, financial news was saturated by two images: the Greek referendum and images of Chinese trading screens bathed in red ink.

Rmb3 trillion
funds available to state margin lender to counteract sell-off

Beijing’s reaction was to bring down its great clunking fist, hard. Brokers and state-run firms were ordered not to sell shares, but to buy-and-hold. Company employees were encouraged to participate in stock buy-backs. Police waded into the offices of the country’s stock regulator, the CSRC, searching for signs of allegedly "malicious" short selling, even though the practice is now legal on the mainland. The government created a state-run margin trader with Rmb3 trillion ($483 billion) in capital, expressly reserved for buying stock and buttressing liquidity at struggling brokerages. It worked: by mid-July, the Shanghai Composite was one of the best performing stock indices on the planet. 

Overvalued

But the future remains unclear, for many reasons. China’s stocks remain massively overvalued – the average price-to-earnings ratio for mainland stocks is 66 times, by far the highest of any of the world’s 10 largest markets. Pricking this bubble without creating another stampede will be tricky. 

Perhaps worse, global investors have signalled their distrust of mainland shares by quietly exiting the scene: In the two weeks from July 3, foreign funds pulled Rmb40.5 billion ($6.5 billion) from mainland stocks. 

Many of the 1,400 stocks suspended at the height of the market rout remain out of action, while the mechanism for approving initial public offerings was frozen indefinitely as Euromoney went to press. Until that ban on new listings is reversed, the country "doesn’t have a working stock market," notes Citic CLSA’s Cheung. 

A final trio of entangled challenges now face China’s leaders. Xi and Li will need to re-convince the world that they are committed to shaking up the country’s financial industry – recent events have seriously dented their reformist credentials. Heavy-handed intervention may also delay the entry of mainland-listed A shares into the MSCI’s global benchmark indices, with a final decision on their inclusion likely now to be delayed by years rather than months. 

Finally, market meddling will have done little to aid Beijing’s desire to see the renminbi included in the International Monetary Fund’s Special Drawing Rights basket of global reserve currencies by the end of the year. A decision in favour once seemed a solid bet. After the tumultuous events of early July, the odds now appear stacked against it.