China’s equity markets are tanking with no end in sight despite the government’s best efforts to contain the extent of fall. The benchmark equity index, the Shanghai Composite Index, has lost over 30% from peaks of over 5000 levels to levels of 3500 over the last two months. China ‘s equity market fall is now making the world nervous, especially as sentiments are hit by Greece Euro exit talks.
Indian markets too are now closely interlinked with global markets and the Sensex, Nifty, INR and ten year gsec are seeing volatility. Will China pull down Indian markets? The answer is both yeas and no, yes in the short run as negative sentiments hurt markets and FII’s sell on heightened risk aversion. No in the longer run as India would receive more than its fair share of global liquidity given that its markets are run transparently and there are no bubbles formed in the markets.
The regulator of the securities market, which is the Securities Association of China and the Government has taken steps to stem the sharp fall in levels of the benchmark indices. The move of the People’s Bank of China (PBOC) to cut its benchmark lending rates by 25 basis points to 4.85 % in the month of June 2015 had failed to arrest the fall in the markets. The first major step the regulator took was to halt the primary market offerings or the initial public offerings where stocks in the earlier issues had risen to the tune of 2900% after listing.
Initial Public Offerings to some extent crunch liquidity in the financial system as funds of investors remain blocked for application for new listings. The move aims at avoiding blockage of funds to stem the fall as most of the stocks may only have sellers and no buyers in stock market trading. It is also an attempt to dissuade investors from selling stocks to buy new ones offered and thereby stabilize markets. Previous IPO bans have lasted as little as three months and as long as 14 months.
28 Chinese companies that had obtained permission from the securities regulator to list shares reported that they would postpone follow-up share issues because of the recent swings in the stock market.
The second move to contain the stock market slump was implemented to create a market stabilisation fund. The fund will get its initial financing from China’s big securities firms. They will invest the equivalent of 15% of their net assets as of the end of June, or no less than 120 billion Yuan (USD 20 billion) in total, in the fund. But that amount is unlikely to be enough. As a result, the People’s Bank of China is expected to provide financing to the stabilization fund either directly or indirectly through the country’s giant sovereign-wealth fund.
A further selloff in stocks would hurt Chinese companies’ ability to raise funds and pay off debt, which, in turn, could add more downward pressure on the economy. Fears also are growing among policy makers that the stock turmoil could lead to instability in the broader financial system.
The Shanghai Composite Index has declined 37.12% from the peak of 5178 to current levels of 3776 in a time period of less than a month. The stock prices had gone up to highly expensive valuations because of a booming primary market (Initial Public Offerings) and rising participation of retail investors in this process. Retail investors had borrowed money in the form of margin funding to take positions in the market.
Debt in the form of margin financing had risen almost fivefold to about two trillion Yuan (USD 330 billion) in the month of June 2015 over June 2014. Margin funding increases the exposure to stocks for investors as they borrow money from their brokers to take bets on stocks (only a margin amount is necessary to take exposure that is several times its value). This trend is prominently visible during times of an extended rally in the stock markets such as the one seen in China in the last one year with equity indices doubling. When the stocks start to fall sharply the decline in the value triggers a margin call (shortage of funds to keep sustaining position) and the broker cuts off the position to recover the margin money.
There is a clear cut case of China’s stock market rallying way far ahead of its economic fundamentals and a correction looks most likely in the current scenario. The magnitude of the correction would be definitely significant but the timing of the correction is what the investors would find out in the near future.
The Shanghai Composite index which is the benchmark index of the Chinese economy has soared 147% in the last one year and 60% from year to date in 2015. The Shenzhen Stock Exchange Composite Index is up 190% on a year on year basis. The Nasdaq Composite which is the benchmark index in the US economy has risen 16% in the same time.
What is driving the rally for the benchmark indices in China? A key factor is that a lot of new wealth in China is constantly looking for an investment avenue to park their money. The real estate market in the Chinese economy was in a bubble when the Government interfered to drive down the speculation. The new wealth was heavily invested in the real estate market that led to the bubble in property prices. Speculative money then went on to chase the Initial Public Offerings (IPOs).
Beijing Baofeng Technology Co. Ltd. offers online audio and video entertainment services. The Company provides a movie player, game website, video download converter, and other network entertainment tools. The stock rose more than 2900% after it got listed on the exchange in the month of March 2015. Many Chinese investors have bought shares using borrowed money. The amount of margin financing, whereby investors borrow from brokers and put up extra collateral if the price moves against them, has more than quintupled over the past year to 2 trillion yuan (USD 325 billion).
Shenzhen-listed companies now trade at an average price to current earnings ratio of 72 times, up from 35 at the start of the year 2015. Of the top 10 stocks by weighting on the Shanghai Composite, only one has risen more than 25% this year. Agricultural Bank of China, the third-biggest stock on the index, is up just 2.7% while China Life has added only 1.5%. The top company on the index by market capitalisation, PetroChina, has gained 11%. Bulk of the money has flown into tech stocks or start-ups that have raised money in this year.
Most of the investments or for that matter speculative money is coming from the Retail investors in China. This comes despite regulators clamping down on margin requirements and leveraged buying.
China unveiled “Made in China 2025” its latest initiative to strengthen start-ups involved in digital technology, cleantech, biomedicine and robotics. Regulators have also lowered the financial requirements allowing tech start-ups to stage an IPO on exchanges. And other changes are making it easier for Hong Kong and international investors to invest in mainland stocks, and vice versa.