If, as events indicate, China’s efforts to soften its economic downturn by fattening its equity market are losing effectiveness, it will clearly not be for lack of trying.
China, whose economy is slowing fast but whose stocks are rising faster, whipsawed investors in recent days.
First, last Friday, securities regulators moved to make it tougher to borrow money to buy stocks and increased the number of company shares it is possible to bet will fall in value. Rule changes came with a stern warning about the risks of selling property or borrowing money to buy stocks.
Prudent moves, you might argue, considering that both H-shares, listed in Hong Kong, often for foreign consumption, and A-shares, listed on the mainland and beloved of small local speculators, have both risen strongly in recent months, in growing contrast to a steady stream of signs of economic cooling.
But when investors took fright over the weekend, leading some futures to predict a 5 or 6 percent fall on Monday, Chinese authorities were swift to act. Not only did regulators make placating remarks on Saturday, but the People’s Bank of China chose Sunday to cut by one percentage point the cash banks must hold in reserve, freeing up more than $200 billion for lending.
At first glance, the cut in the required reserve ratio was simply a sop to markets.
“It’s a political goal to create wealth effects in both A- and H-share markets, so that Beijing can utilize the stock market to stimulate innovation and entrepreneurship and channel liquidity to the real economy to hedge economic downside risk,” China equity strategists at HSBC wrote in a note to clients.
In other words, and many have been trading on this assumption, China shares are a good bet because a highly powerful, highly centralized government wants them to go up.
That may well be true, and is certainly consistent with events, but if Chinese authorities hoped that some liquid sugar for the financial system would stabilize trading, they were wrong. Stocks in Hong Kong fell 2 percent on Monday and Shanghai stocks tumbled 1.6 percent on record volume.
Investors reasoned, not without cause, that authorities were either ham-handed, scared themselves by the underlying economic fundamentals or some combination of the two.
U.S. and European stock investors, however, took a different view, pushing equities sharply higher, partly in reaction to China’s move.
Some, not all, stories are too good
We should perhaps pause to appreciate just how, uh, enthusiastic investors, especially locals, had become about Chinese stocks. The ChiNext, a sort of Chinese Nasdaq of smaller companies, is trading on a price-equity ratio of 90. In one recent week 1.67 million new retail brokerage accounts were opened and a surveys show that two out of three people opening them have less than a high-school education.
As with all market manias, and indeed, all fantastic investments, China has a great story. While its stock market has soared, it has not, over the longer run, grown in size proportionally to the size of China’s economy in the global whole. Both local investors and global ones are thus structurally under-invested in China.
On one view China will produce lots of new shares to meet demand, diluting existing investors, many of whom may be buying in at levels well above companies’ underlying ability to produce earnings, even over the longer-term.
So although Chinese authorities may welcome the stimulus from a stock market boom, given that the first quarter’s 7 percent annual growth clip was the weakest in six years, the reserve ratio cut may have had other underlying motivations.
Wei Yao of Societe Generale points out that the very success of the stock market, with many new offerings and all those new accounts, is draining funds from the banking system. That, in conjunction with the advent of a new deposit insurance plan coming on May 1, may be making conditions tough for banks seeking loans from one another.
On this view, the reserve cut is partly fine-tuning rather than a panic in reaction to the thought of a sell-off.
It is also true that China is in the process of liberalizing its financial system. The very high 18.5 percent reserve ratio for banks is a relic of an earlier time, when China needed a way to soak up all of the money flowing into the country, both because of huge trade surpluses and so-called speculative hot-money.
Still, the combination of bubble-like valuations, inexperienced investors and highly active officials could be a combustible one.
Volatility is the most reasonable thing to expect.
