Tuesday, July 14, 2015

Is China’s use of state control, money to stem stocks rout doomed to fail?

By Tom Mitchell, Gabriel Wildau and Josh Noble

July 13

Ms Ginger Zengge had a good feeling about the stock market. Though the Shanghai Composite Index had risen 150 per cent over the previous 12 months and just hit a seven-year high, she saw a “buy” signal that other investors had probably overlooked: President Xi Jinping’s birthday.

“When the index dropped on June 15, which happened to be Mr Xi’s birthday, I thought, ‘Yes, now is the time to buy!’,” said Ms Zengge, 26, who works for a security ratings company in Beijing. She bought more shares later that month.

Unfortunately for Ms Zengge, she decided to buy near the very top of a remarkable bull run in China stocks. After reaching a peak of 5,166.35 on June 12, the Shanghai index fell 30 per cent in only three weeks. By July 3, the Shanghai and Shenzhen exchanges shed almost 18.6 trillion yuan (S$4.1 trillion) in market capitalisation.

Since then, the ruling Chinese Communist Party (CCP) has launched an unprecedented series of measures —each seemingly more desperate than the last — to halt a crisis in the stock markets that could derail its 25-year experiment with capital markets reform.

Ms Zengge’s post-mortem of her investment decision sums up the sense of confusion as China teeters on the brink of a potentially much-larger financial and economic crisis, which could hurt the global economy and have political ramifications for the CCP. “I really regret it,” she said on Wednesday, as the Shanghai and Shenzhen exchanges failed to respond to Beijing’s attempt at propping up the markets. “The government is trying to save the market, but falling short. I think I will stay away from stocks in future.”

By Friday, the losses began to reverse, as the Shanghai index wrapped up a big two-day gain of 10.6 per cent. But the rebound came only after heavy state intervention — including using the central bank to buy shares — that may have done long-term damage to the credibility of markets that the Chinese leadership is so eager to promote.

“While we sympathise with the sense of urgency to calm investors, we are concerned about two potential side effects,” said Mr Wei Yao, chief China economist at Societe Generale.

First, shifting the equity market risk from retail investors to financial institutions creates moral hazard problems and potentially increases systemic risk. Second, measures such as restricting short-selling and halting market trading might only delay risk from being exposed.”
The sell-off has come at the worst possible time for Mr Xi and his Premier, Mr Li Keqiang. China’s economy is growing at its slowest annual rate in a quarter of a century. Second-quarter growth figures are due out this week.

Mr Kevin Lai, regional economist at Daiwa Securities, believes the share price rout is merely a function of worsening economic fundamentals coming back into focus and said any success the government has in holding back the tide will only be temporary.

“It’s impossible for them to sustain this game,” Mr Lai said. “The market going down is natural and logical, but the government doesn’t want that to happen.”

It remains unclear how much money investors have borrowed to put in stocks. Also unclear is just how many shares have been pledged as collateral against bank loans — a practice that, if widespread, raises the spectre of a series of brokerage or bank failures. It is the unknown potential impact of these two “transmission mechanisms” in the wider economy that appears to have spooked the Chinese government.

Margin lending, in which investors borrow money from brokerages to buy stocks, soared from 698 billion yuan at the end of October to a peak of 2.7 trillion yuan on June 18. But an unknown amount of grey-market margin lending also proliferated, funded by shadow banks through complex structures known as “umbrella trusts”.

Over recent weeks, the China Securities Regulatory Commission (CSRC) loosened margin lending rules, only to tighten them later — just one sign of official concern about the market rout and confusion about how to deal with it.

One 25-year-old investor from Suzhou, who said his losses were “equivalent to the cost of a BMW Mini Cooper”, neatly summarised the challenge facing China’s leadership. “I’m not going to sell because I believe in Xi and Li,” Mr Aaron Zhang said. “The pressure is on them. If Li can’t deliver 7 per cent growth this year, then his political career is over ... But I think this is highly unlikely. I still believe that 6,000 or even 8,000 points is not a fantasy. The market will bounce back before the end of the year.”
At the older end of the investor spectrum are the retirees gathered in the hall at Dongzhimen China Securities in Beijing, which could easily be mistaken for a hostel for the elderly. One woman, who declined to give her name but said she is almost 80, invested 20,000 yuan when the market was at 5,000 points. “I’ve lost two-thirds of my money,” she said, her voice cracking. “I really want it back and when I get it, I will never invest in the stock market again.”

“There were a lot of media reports about the index topping 5,000, 6,000,” she added. “The newspapers were lying.” These elderly investors were entering the back half of their lives at the moment when China began to embrace reform. “Old people often don’t understand economics,” said Mr Nie Riming, a pensions expert at the Shanghai Institute of Finance and Law. “They are easily duped.”


The government is now trying to prop up markets that it had earlier helped inflate to dangerous levels. The state media was a cheerleader during the market’s bull run, reinforcing impressions that the government was supporting the rally. An April commentary in the People’s Daily, the CCP’s flagship newspaper, is now infamous in China for declaring that “4,000 (points on the Shanghai Composite index) was just the beginning”.

“The reason behind the rally is macroeconomic support for China’s development strategy and the intrinsic force of economic reforms,” the paper said.

Brokerages and fund companies were complicit in the propaganda effort, encouraging the perception that government policies would drive the market higher. Investment storylines talked about “concept stocks” linked to big themes such as state-owned enterprise reform, and Mr Xi’s New Silk Road infrastructure blueprint for Asia and Europe.

The same month that the People’s Daily commentary ran, a Shanghai bank branch placed a blackboard outside its premises. Chalked on it was a message urging passers-by to: “Keep in step with policy and seize market trends! Selling red hot: SOE (state-owned enterprise) reform, New Silk Road, the most bullish concept stocks!”

After the market turned on June 12, state media showed nowhere near the same enthusiasm for the story. News outlets that once routinely featured the daily market move buried the update. Some journalists have been instructed to refrain from using phrases such as “equity disaster” and “market rescue” in their reporting.

“What the government is ultimately worried about ... is its credibility and public support,” Mr Andrew Batson and Mr Chen Long at Gavekal Dragonomics, a Beijing-based research firm, wrote last week. “Though the months-long propaganda blitz urging people to get into stocks was clearly a mistake, the government may still feel compelled to support the market to show it can deliver on its promises.”

The CCP’s efforts to resuscitate the market began at the end of June, three weeks after the bubble burst. China’s central bank cut both the benchmark interest rate and commercial banks’ reserve requirement, with the latter move estimated to have injected around 470 billion yuan into the banking system.

Three days later, the state-backed Asset Management Association of China urged investors not to “kill the goose that laid the golden egg” and seize the-then 20 per cent fall as an “investment opportunity”. As the bloodletting continued into early this month, the CSRC said it would investigate market manipulation, while local media reported that the authorities were pressuring traders not to short the market through index futures.

The rescue measures included a 120 billion yuan pledge by state-owned brokerages to help drive the Shanghai Composite back up to 4,500, and directives to controlling shareholders and company executives not to sell shares. It was as if the Communist party, which harbours powerful factions that are allergic to risk in all its forms, decided that it could simply turn the market off at will when it became too volatile.

Some believe the implications for Mr Xi’s larger and ostensibly transformative reform programme are ominous. In a note to clients on July 5, Mr Junheng Li at JL Warren Capital called the rescue effort “a huge step back in the course of market reform”.

One person who advises Chinese policymakers added that the intervention begged the question of whether it has “been a major blow to the people who wanted to move forward with reform, (because) if you are against reforms you can say: ‘See, I told you so’”.

The market dysfunction on display last week in China was such that by Thursday morning, about half of the country’s listed companies had suspended trading in their shares — an apparent effort to avoid the rout that insulated about US$1.4 trillion (S$1.89 trillion) in market cap from the sell-off. It amounted to a clandestine form of market closure that was welcomed by some.


But the most extraordinary measure unveiled over the past week was central bank-funded equity purchases — an operation branded by some observers as “quantitative easing with Chinese characteristics”.

Just hours ahead of the markets’ opening on Monday morning, the CSRC announced that China Securities Finance (CSF), a hitherto-obscure state company that lends to brokerages, would funnel central-bank-funded liquidity to its clients.

The central bank did not confirm the operation itself until Wednesday, when it was also revealed that CSF had amassed a war chest of about 260 billion yuan.

It is still not clear how much of that comes from the central bank, as CSF is also borrowing from the interbank market and issuing its own bonds.

“At first, the central bank didn’t show much support,” said Mr Ye Tan, an independent financial commentator, noting potential disagreement within the government over the rescue programme. “Wednesday was the first time it declared its stand. But the central bank can’t shirk responsibility. It supplies the weaponry.”

Sceptics abound. “You have to ask is what they did effective, did it work?” one person who has regular dealings with the CSRC told The Financial Times. “To have so many companies seeking to hide themselves from investors by seeking suspension is pretty embarrassing.”

“You’ve got two things happening that shouldn’t be happening,” he added. “The state is intervening in the market very directly to prevent prices going down, and listed entities are withdrawing from the market. They are voting with suspension to say they don’t think the government knows what it is doing, that it’s not going to work. Both the government and the listed entities have a lack of confidence in the market.”

Even the Finance Minister of Russia, a country desperate for China’s friendship and economic support, seemed to cast aspersions on the credibility of China’s financial managers. “We hope that the Chinese regulators’ ... action will be effective,” Mr Anton Siluanov said on Wednesday after Mr Xi attended a summit of emerging markets in Russia, alongside President Vladimir Putin and his counterparts from Brazil, India and South Africa.

“The prices of oil and certain metals sagged (last week),” he added. “We attribute this to the lack of stability in the Chinese financial market.”

Adds a Beijing-based diplomat: “Their approach is more state control and to throw more money at the problem. But even in China, funds are not unlimited.” 


Tom Mitchell, Gabriel Wildau and Josh Noble are respectively Beijing correspondent, China finance correspondent and Asia markets correspondent for The Financial Times.

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