China's stock market rise was doomed to spiral out of control

Das Capital: The A-share bubble was engineered to compensate for growing economic problems

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The Independent Online

Oriental mystery swathes everything in China, including its stock market. Between 2013 and mid-2015, the Shanghai Stock Exchange Composite Index rose by about 250 per cent to over 5,000. Since reaching its peak in June 2015, the indices have fallen sharply, by 27 per cent. The loss equates to about $3-4trn. The phenomenon is not new. In 2007/2008, the Shanghai index also topped 5,000, a rise of 90 per cent, only to fall 70 per cent.

Chinese stock markets are complex, involving multiple types of shares (A, B and H) and convoluted ownership arrangements. The stock market itself is relatively unimportant within the Chinese system. Equity issues contribute 5‑10 per cent 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 about 25-35 per cent of gross domestic product, well below the levels in the US (150 per cent) and most developed economies (85-100 per cent).

Retail investment is modest with only about 10-20 per cent of household wealth being held in the form of shares, well below levels in developed countries. Fewer than 10 per cent of Chinese households actively trade shares while another 4 per cent are exposed to the stock market through mutual funds.

About 30 per cent of the value of the Shanghai market is made up of large companies. Many are government related, with a large proportion of shares held by state firms and government agencies. The rest of the market consists of numerous small and medium-sized enterprises; it is these stocks that attract many investors. The recent stock rises were mainly in these smaller stocks, which increased by 100-400 per cent. In contrast, the prices of larger mainland companies rose only 20-30 per cent during the corresponding period.

Regulation is poor, and many companies list on Chinese exchanges as they would fail the requirements of overseas exchanges, such as those in Hong Kong or the US. 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.

The primary factor behind the boom was government policy. Investors thought the government would ensure that shares prices would keep rising.

The Chinese political and economic system since Deng Xiaoping has been held together by a simple compact. In return for recognising the Chinese Communist Party’s political control, the majority of the population would see their living standards improve. A few well-connected insiders and a growing middle class would be allowed to accumulate wealth. The A-share bubble was engineered to compensate for China’s growing economic problems, which threatened this tacit arrangement.

China’s economic growth has slowed. It is now forecast to be about 7 per cent, well below the nearly 12 per cent growth it averaged between 2002 and 2008. In the real estate market, a big source of rising wealth, prices are down 20-30 per cent. The government has restricted wealth management products offered by China’s shadow banking system and limited higher-returning investment opportunities for investors looking to protect their purchasing power.

The government undertook targeted easing of interest rates and loosened restrictions on lending to boost growth as well as help manage the reduction of shadow banking and the 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 repay bank borrowings. Taking advantage of conditions, Chinese companies have raised about $100bn in initial and secondary stock offerings.

A more charitable interpretation would argue that the development of equity markets was part of a broader reform agenda. It was intended to rebalance the financial system from its excessive reliance on bank loans and create a dynamic stock market to finance future growth. Policy makers encouraged the creation of exchanges to fund start-ups. 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 to deregulate, China increased the limit for foreign funds investment to $150bn (from $80bn). It also established a trading link between the Shanghai and Hong Kong exchanges to allow foreigners greater access to Chinese stocks.

Chinese policy makers have long been influential 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”.

Satyajit Das is a former banker and author of ‘Extreme Money’ and ‘Traders, Guns & Money’

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