China’s Stock Market Crash: Part 1 – Communist Shares
By Satyajit Das
Between 2013 and mid-2015, the Shanghai Stock Exchange Composite Index rose by around 250% from around 2,000 to over 5,000. Other Chinese indices, especially the Shenzhen Stock Exchange and the ChiNext index, dominated by smaller and technology shares, also rose sharply. Since reaching its peak in June 2015, the indexes have fallen sharply, by around 30%. The loss equates to around US$3-4 trillion dollars.
The phenomenon is hardly new, with similar episodes in 2001 and 2007/ 2008. In the later, the benchmark Shanghai Composite index also topped 5,000, a rise of 90% followed by a fall of 70%.
There is an obvious contradiction between private property, stock markets and socialism. Mao Zedong famously used the term “capitalist roaders” to castigate Communist Party members who favoured market driven economics.
Chinese stock markets are complex, involving multiple types of shares and convoluted ownership arrangements. There are A-shares: Renminbi denominated shares in mainland China-based companies whose ownership is restricted to mainland citizens and foreigners under the regulated Qualified Foreign Institutional Investor (QFII) system. There are B-shares which are quoted in foreign currencies (such as the US dollar) and can be purchased by domestic and foreign investors (with a foreign currency account). There are H-shares: Hong Kong dollars denominated shares in Chinese companies which are listed in and trade on the Hong Kong Stock Exchange.
There are even shares which are not really shares, such as the rights in Variable Interest Entity used by foreigners to get around ownership prohibitions to acquire stakes in Chinese Internet companies like Alibaba. These are typically Cayman Islands companies which use contracts to provide an economic interest in a Chinese business. In the case of Alibaba, its Chinese assets are owned by founder Jack Ma and other related parties. The Cayman Islands Company has contractual rights to the profits of Alibaba China. Such rights may be deemed illegal by Chinese authorities or be unenforceable. It is also difficult to protect the business assets and earnings from actions by the legal owners.
The stock market itself is relatively unimportant within the Chinese system. Equity issues contribute 5-10% of all capital raisings. The vast majority of funding is in the form debt, primarily from banks. The stock market is small relative to the size of the economy. Historically, the total free float value (shares available for trading) in China is around 25-35% of Gross Domestic Product, well below the levels in the US (150%) and most developed economies (85-100%).
Retail investment is modest with only around 10-20% of household wealth being held in the form of shares, well below levels in developed countries. Less than 10% of Chinese households actively trade shares while another 4% are exposed to the stock market through mutual funds.
Chinese stock markets are also different. Around 30% of the value of the Shanghai market is made up of large companies. Main are government related, where a large proportion of shares are held by state firms and government agencies. The rest of market is made up of numerous small and medium sized enterprises. It is these small and medium capitalisation stocks which attract many investors. The recent stock rises were mainly in these smaller stocks which increased by 100-400%. In contrast, the prices of larger mainland companies rose by a more modest 20-30% during the corresponding period.
The investment environment is also different. Regulation is poor, with many companies listing on Chinese exchanges where they would be unable to meet the more stringent requirements of overseas exchanges, such as Hong Kong or the US. Information sources are frequently unsatisfactory. As is well documented, Chinese macroeconomic data is unreliable. Company specific financial disclosure, dividend payments, audits, governance and protection of shareholder rights are poor. Unanticipated government intervention to achieve policy objectives is not unusual.
President Xi’s Boom
China’ recent run-up in share prices has many drivers.
In an interesting reversal to the experience in developed economies, the performance of the Chinese stock market has not until the recent boom matched its stellar economic growth. In the past 20-25 years, investors have earned a modest 1-2% per annum. In the 20 years commencing June 1993, the Chinese stock market rose around 20% until the recent sharp increase, compared to gains of around 400-500% in the S&P 500 and over 300% in emerging markets. The Shanghai market was until recently valued at around 6-8 times earnings, well below the 12-15 times of international markets. Investors, especially international fund managers, saw the market as undervalued.
But the primary factor behind the boom was government policy. Investors invested believing that the government would ensure that shares prices would keep rising. The A-share bubble was engineered to compensate for the China’s growing economic problems which threatened this tacit arrangement.
China’s economic growth has slowed. It is now forecast to be around 7%, well below the nearly 12% growth it averaged between 2002 and 2008 and 8-9% since 2008. The 7% growth in 2015 would have been around 5.5-6% except for fall in import prices and a fall in inflation. Nominal growth is sluggish.
The real estate market, which was a significant source of increasing wealth, is no longer booming. Prices are down around 20-30%. The government has restricted wealth management products offered by China’s shadow banking system, limited higher returning investment opportunities for investors looking to protect their purchasing power.
The government undertook targeted easing of interest rates and loosening restrictions on lending to boost growth as well as help manage the reduction of shadow banking and slowdown in the property sector. Lower rates helped fuel the rise in stock.
Higher shares prices were also intended to assist heavily indebted property companies, local government financing vehicles and state owned businesses. Favourable stock markets would enable these businesses to raise equity to pay back bank borrowings. Taking advantage of conditions, Chinese companies have raised around US$100 billion in initial and secondary stock offerings.
The development of equity markets was part of a broader reform agenda. It was intended to rebalance the financial system from its excessive reliance of bank loans and create a dynamic stock market to finance future growth. As part of this agenda, policy makers encouraging the creation of exchanges to become a funding source for start-ups and innovative companies. The state-controlled news media supported the policy, publishing favourable pieces on the prospects of the technology and Internet sector.
In a sop to international pressure regarding deregulation, China also increased the limit for foreign funds investment to US$150 billion (from $80 billion). It also established a trading link between the Shanghai and Hong Kong exchanges to allow foreigners greater access to Chinese stocks.
Chinese policy makers, historically, have played an important role in directing savings into specific assets classes or investments as part of their management of the economy. The engineered stock market rise was a continuation of that process. The process quickly spun out of control.
It was as an old Chinese proverb states akin to “drinking poison to quench one’s thirst”.