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By James Yardley, Research Analyst

In just over three weeks $3 trillion has been wiped off Chinese stock markets. The horrific collapse follows a 150% gain in the Shanghai composite, after the Chinese government encouraged people to invest in the stock market.

The government should have addressed its surging stock market far earlier. This was a state sanctioned government rally, fuelled by borrowed money and margin-based financing (borrowing money to buy stocks). The regulator was asleep, by the time they cracked down on margin lending on the 13th June it was already far too late. What followed was a 40% correction in the Shanghai and Shenzhen markets. The Chinese governments reaction to the crisis has been extraordinary. Now the bubble has popped, rather than accepting the necessary pain of deleverageing, the Chinese government is instead doing everything it can to re-inflate the bubble.

Many professional investors and commentators, including Chelsea Financial Services, predicted the crash. The extraordinary stock-market gains have been driven almost entirely by speculation and borrowing, rather than fundamentals. 80% of the Chinese A share market is owned by retail investors making it very susceptible to 'herd-like behaviour' and volatile short term moves. Chinese economic data has been weak over the past year and growth has been slowing. There have been few fundamental reasons for stocks to rise as much as they have done and the surge in markets bears all the signs of a classic bubble. Below are some of the measures the government has used boost the stock market.

  • All initial public offerings (IPOs) have been suspended
  • 21 securities firms released a statement saying they will spend 120bn yuan buying stock
  • Pension funds pledged to buy more stocks
  • The Bank of China cut interest rates and the government announced a $40bn economic stimulus package
  • The Bank of China announced it would support brokers with loans
  • Controlling shareholders have been banned from selling shares for six months
  • The government has allowed more than half of shares listed to suspend themselves from trading to prevent further falls
  • Government-owned companies have been banned from selling shares in other companies

A policy disaster or smart stock-market management?

The Chinese communist party is used to winning, but has it finally met its match in the form of the capitalist stock market? Never in the history of stock-market crashes have we seen the level of measures which Beijing has announced. The question is, will they succeed where every other government has failed in the past? Who will ultimately win the battle, communist government policy or the animal-driven capitalist fear of a falling market?

Predictably Beijing initially reacted to the crisis by blaming and threatening short sellers. Many governments have done this during a market crash. In any case, there is very little shorting in the Chinese market but it gives the government someone to blame. 'Finding culprits is a political priority for Beijing', according to the Financial Times.

In its latest, and most controversial measure, the Peoples Bank of China has begun lending directly to the China Security Finance Corporation to fund share purchases. This means the government itself is now borrowing money to buy shares directly in a desperate attempt to prop up the market. Effectively this is the ultimate extreme form of quantitative easing (QE).

History is not on the side of governments when it comes to controlling stock markets, but then no government has ever had the same level of control and power as the Chinese government. It may well be able to engineer a short-term bounce but at the same time it has damaged the credibility of its financial markets.

What makes the governments panic so extraordinary is that the index has only fallen back to a level it was trading at in March. The Shanghai composite is still up 77% over a year!* It is bizarre that the regulator is in such a complete panic when the market is still much higher than it was a year ago. Drawing a line in the sand at such a relatively high level should make us all nervous. The Shanghai and Shenghzen are still expensive by historical measures.

One reason for the government's panic is that the crisis has become political. The Chinese middle classes have been encouraged to invest in the stockmarket and many are now losing their hard-earned savings. There is a real danger of social instability and unrest.

A Loss of Credibility

More than 1,400 companies, more than half of listed shares, have stopped trading. In the future, why would investors want to own stocks they may never be able to sell? Consider the controlling shareholders who have been banned from selling their holdings for six months. Why would they have any interest in holding their assets in the future. Won't they sell them as soon as possible? The whole credibility of the market has been thrown into question.

The government's relaxation on margin trading and further interest rate cuts will only re-inflate the bubble and only postpones an inevitable crash in the future. Banks are now being encouraged to lend money to companies that want to buy their own shares. As the Financial Times said, 'Rather than reining in the leverage that has engorged a dangerous equity bubble, the authorities are egging it on in the interests of short-term salvation.'

The latest decision by the government to intervene and buy shares is unprecedented. You cannot have a functioning financial market where the government itself is buying up shares. Stock markets need to be allowed to go down as well as up, even if this is sometimes painful. The whole point of a stock-market is to allocate capital efficiently. Beijing's recent policies are in danger of shifting risk from the retail investor to institutions. This could increase systemic risk and danger to the economy in the future.

In an efficient market prices will always correct themselves to the right level in the long run, no matter how hard the Chinese government tries to distort prices. At the moment the government has bought itself time but it will need radical reform and exceptional management to gently cool the stock market from its over-leveraged position and return to normality. I am sceptical they will be able to achieve this and I suspect we will witness continued volatility going forward.

The Risk to the Rest of the Chinese Economy

On the face of it the wider Chinese economy is somewhat insulated from the stock-market crash. Despite its recent surge in popularity only about 10% of Chinese wealth is held in the stockmarket. Banks are not allowed to participate in margin lending directly, but many are indirectly exposed through lending to brokers. In May, Fitch argued that there were risks posed by margin lending but that the banks exposure was currently small and 'unlikely to pose a significant risk to major institutions'.

Given the Chinese economy is already fragile a stock-market crash does pose a significant risk, although currently it is unlikely to have the negative wealth effect cycle that some fear. Mark Williams, fund manager of Liontrust Asian Income believes the risk to the Chinese economy has been overstated but that China's economic transition has suffered a significant setback.

Conclusion

China's stock market is largely isolated from other world markets providing some protection to investors in other parts of the world. The greatest risk is undoubtedly the impact that any crash might have on the Chinese economy, which would have wide-ranging consequences. In my view the Chinese economy is of much greater concern than Greece. There is no comparison between the two economies in terms of size and importance. The Chinese economy is now the second largest in the world. Any collapse in the economy will likely send stockmarkets around the world into a bear market so the situation is something all investors should be following closely. Currently, the consensus is that the wider economy and stock market are only loosely correlated, however the government's efforts to re-inflate the equity bubble are increasing these risks for the future.

In the short term the Chinese government will probably successfully drive the stock-market back up, but this will only postpone an even bigger correction in the future. If I have learnt anything from working in financial markets, it is that artificially distorting assets has consequences. I would not be surprised if the Shanghai composite rises above its previous peak. If this does happen in a short space of time I would be extremely wary and it will only be a matter of time before Beijing is overwhelmed by animal spirits. However, if the government uses the time it has bought to crack down on margin lending, shadow banking and other problems in the system, they may yet be able to manage the stockmarket effectively. Investors should think very carefully before investing in a heavily distorted and inefficient market but this a situation all investors everywhere should be watching.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. James' views are his own and do not constitute financial advice.

*As at 09/07 bloomberg.com

http://www.ft.com/cms/s/0/9b346454-25e8-11e5-9c4e-a775d2b173ca.html#axzz3fPEIWoA8
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http://app.ft.com/cms/s/0/6963a7c6-1a5a-11e5-a130-2e7db721f996.html
http://app.ft.com/cms/5f28a750-286c-11e5-8613-e7aedbb7bdb7
http://www.liontrust.co.uk/ProfessionalAdvisers/NewsandViews/LiontrustBlog/tabid/291/entryid/1751/Default.aspx
http://www.ft.com/cms/s/0/6eadedf6-254d-11e5-bd83-71cb60e8f08c.html#axzz3fIyxqUeg
http://www.ft.com/cms/s/0/9382843e-2511-11e5-bd83-71cb60e8f08c.html#ixzz3fJFoEhpu
http://www.theguardian.com/business/2015/jul/08/china-stock-markets-continue-nosedive-as-regulator-warns-of-panic