Why is the Shanghai Composite Index the worst performing equity index?
China’s benchmark equity index the Shanghai Composite Index (Index) is the worst performing equity index on a year on year basis as of end August 2012. The index has lost 19.5% against positive performance of other major global indices. The only other major market that has not given positive returns is the Hong Kong equity index, the Hangseng index, which has given marginal negative returns over the year. In comparison to China and Hong Kong equity market performance, Sensex and Nifty have given returns of 7.4% and 12.5% respectively on a year on year basis. The US equity index S&P 500 has given returns of 16% and the German equity index the Dax has given returns of 23%. Why is China the worst performing equity market globally and what does it mean for India and other equity markets that have done well on a year on year basis?
The currency could be a factor in China’s equity market underperformance on an absolute basis. The Renminbi (CNY) has hardly moved against the US Dollar (USD) on a year on year basis with the CNY gaining 0.6% against the USD over the year as of end August 2012. On the other hand the Indian Rupee (INR) has lost 21% and the Euro has lost 13.5% against the USD over the year. Hence for an FII investing in USD in markets of China, India and Germany has, on a currency adjusted basis, lost 19% and 8% in China and India (taking Nifty performance of 12.5% gains) while the FII has gained around 10% by investing in German equities. The US equity markets have give the best return on a currency adjusted basis as the USD has strengthened against the majors.
The currency factor is applicable only to FII’s investing in USD in foreign equities. The local investor in China has suffered losses while in India, US, and Germany the local investor has gained. Hence the poor performance of China’s equities is a worry factor for global equity markets as the performance has some fundamental reasons behind it.
China’s economy is facing many issues
China is seeing growth slowing down with GDP growth for the second quarter 2012 coming in at an annualised rate of 7.6%, the slowest growth rate seen since the first quarter of 2009 and the sixth straight quarter of fall in GDP growth. China accounts for around 20% of the world’s economic output and fall in economic growth in China does have repercussions globally.
China was facing an inflationary threat in 2011 with inflation touching multiyear highs of 6.4% in June 2011. The country faced a property bubble with real estate prices soaring by 100% to 150% in the 2007-2011 period and bank loans to real estate were under threat on the prospects of the bubble bursting. Property prices have come off over the last one year but given the weak economic growth in China, banks still face issues of real estate loans turning bad.
China’s corporate profits are reflecting the equity market pessimism with industrial group profits down 2.2% in the first half of 2012 against a 29% growth seen in the first half of 2011.
The Eurozone sovereign debt crisis has affected China’s exports with just a 1% growth in July 2012. Exports contribute to close to 30% of GDP and any export growth slowdown will hit the economy hard.
China has a tough task ahead. It has to revive its economy without going making overinvestments as many of its past investments are hanging on banks books as potential non performing loans. Local governments borrow from banks to invest in infrastructure to show growth and in such cases economics does not come into play. Chinese banks are sitting on close to USD 1.7 trillion of local government debt, which accounts for 27% of GDP.
The one positive factor for China is inflation, which has come off to below 2% levels as of July 2012 from last year’s levels of 6.4%. China can cut rates and give more funds to banks by reducing reserve ratios. China has cut rates twice in 2012 and has reduced bank reserve ratios by 150bps over the last eight months. However given the excessive lending by banks to real estate and infrastructure, rate cuts may not help as banks worry about bad loans.
What is the effect of China’s weak equity markets on global markets including India?
The sharp outperformance of global and Indian equities over Chinese equities in local currency terms indicates that the problems in China are much more than the problems across the globe. The question is will China’s problems affect other economies? China’s issues may or may not affect other economies negatively. On the positive side weak Chinese economic growth helps keep commodity prices stable (Reuters CRB commodity index is down 9% year on year) and this helps keep inflation down globally. The strong Chinese currency helps countries that have seen their currencies weaken as it makes them more competitive in exports. FIIs too will prefer countries where currency is cheap rather than expensive.
On the negative side weak Chinese economy will pull down economies of many countries including Japan and other South East Asian countries that have high trade linkages with China. A weak Chinese economy can pull down global growth and this can lead into a self fulfilling cycle of falling growth.
The markets are suggesting that a weak Chinese economy is helping other economies and hence the difference in performance. This trend could continue until China gets back on its feet.