19 April 2019
Spot the difference. Photos: Reuters
Spot the difference. Photos: Reuters

A-share market: is Beijing digging its own grave?

I have a son. He’s six years old.

He enjoys reading, tae kwon do and learning about dinosaurs.

Like most kids, he also enjoys games, especially when he wins.

Also like most kids, he used to occasionally change the rules of a game midway through if he noticed that he was losing.

But now that he’s six, he’s learning that he doesn’t have to win every game every time for life to be OK.

Beijing regulators and politicians are learning an equally simple lesson: you cannot control a free market.

But as they struggle to reinflate the bubble they created, they are learning another lesson: Chinese investors, like any investors in a free market, can vote.

Their voting is not with ballots but with brokerage orders, through their decisions to buy, sell or hold assets.

And so far, Beijing’s orders, encouragements and threats aimed at quickly reinflating the bubble it created have received a vote of no confidence.

The more policy Band-Aids Beijing throws at the problem, the more it demonstrates that it can’t control a free market.

The more it muscles equity prices up through brute force — capital injections, coercion or stopping trading to lock investors’ money in stocks — the more it destroys what little trust investors had in the Chinese financial system.

This short-term thinking has already killed far more future economic value for China than whatever is lost in this bubble.

An impossible balance

The China Securities Regulatory Commission has an impossible job: like any stock market regulator, it’s supposed to maintain trustworthy and orderly markets.

But it’s also supposed to uphold market valuations.

These goals conflict.

A country can have total control, or it can have free markets.

It cannot have both.

But Beijing wanted both.

Its logic was understandable, even if most economists would consider its judgment inexperienced.

The CSRC, along with other policymakers, saw growth in China’s gross domestic product declining, weak export levels and — most importantly — official debt approaching 300 percent of GDP (unofficial debt brings that number higher).

By boosting the stock market and then reopening the market for initial public offerings, policymakers hoped to inject equity into the private sector.

Beijing likely wanted to add equity to overleveraged banks in particular – but knew they had to trade at much higher valuations before issuing new shares.

And Beijing policymakers, long considered by the rest of the world to be insecure about their public image, likely wanted a stock rally to add good economic news to China’s newsfeed.

If China can create empty cities and empty roads in the middle of nowhere, it can surely create a stock rally from nothing, too.

By encouraging mainlanders to buy stocks with propaganda campaigns, encouraging them to buy even more by opening up margin lending and by lowering the People’s Bank of China’s benchmark interest rates four times, from 6 percent to 4.85 percent, Beijing got the stock rally it wanted.

Actually, it didn’t.

Rather than adding long-term investment money to high-quality companies, investors seized the opportunity to make quick profits using borrowed money.

The CSRC inadvertently brought Macau to the mainland.

Farmers, fishermen and laborers opened more than a million brokerage accounts per day at the peak, pouring money into stocks as margin debt rose more than 500 percent in one year to reach 3.5 percent of GDP – which Goldman Sachs says is the highest ratio in the history of global equity markets.

Margin equaled 10-17 percent of the total value of traded shares, by various estimates.

And these are just official margin debts that don’t include China’s massive shadow margin lending.

Shanghai shares alone rose more than 150 percent, but the banks and steady large-caps — the sorts of companies policymakers most wanted to recapitalize — barely rose.

Investors were too busy chasing quick profits in hot stocks.

Some days, the stock turnover in China’s exchanges was greater than the turnover in the rest of the world’s exchanges combined.

China went from having a slowing economy and a debt problem to having a slowing economy, a debt problem, a stock bubble problem and a margin debt problem.

The bungled response also worsened China’s trust problem — China’s biggest economic “keep out” sign by far.

Local investors seemed to trust Beijing at the beginning of the rally — or at least trusted that other investors would trust Beijing, creating an opportunity for quick profits from the crowd frenzy.

But when the bubble began to burst — all bubbles burst eventually — Beijing’s frantic desperation to change the rules of the game midway through undermined the confidence of investors both inside and outside China.

Before seeing Beijing’s recent behavior, many foreign investors were feeling more optimistic about China.

China’s shares were on course for inclusion in world stock indexes.

China was liberalizing its financial markets, seeking greater respect on the international scene.

China was talking about freer capital movements.

Beijing undoubtedly wanted the economic benefit from all these actions.

But taking benefit from a group requires playing by the rules of the group.

The world’s investors now know that instead of abiding by international standards, Beijing will attempt to manipulate markets whenever it wants and however it wants.

Foreign investors have withdrawn 40 billion yuan (US$6.45 billion) from mainland shares through Shanghai-Hong Kong Stock Connect since last month.

The number is small only because foreign investment was still small.

What should Beijing do?

Beijing will prioritize short-term control above all else.

It always does when it feels nervous.

But for the benefit of China’s economy, the best thing to do would be nothing.

The rest of the world will trust China’s stock market — if it’s still possible — when they see that mainland investors don’t treat it as a casino and that the government doesn’t see it as a game the government has to always win.

Any reasonable economist in any country, including China, would agree that a stock market is healthiest when it channels long-term investment to high-quality companies and lets economics determine which companies receive capital and how much.

That seems obvious, but China’s stock markets barely do this, partly because investors have learned to profit from erratic government intervention instead of from finding high-quality companies with high-quality management teams.

Such companies often list their shares outside China, because they’re better appreciated elsewhere.

One point in Beijing’s defense.

Its mistakes and blunders seem normal for any country adapting to a free market after decades of total state control.

Russia, for instance, struggled significantly more 25 years ago — and retrenched.

The Chinese people grasp enterprise and capitalism expertly.

But Beijing seems terrified to admit mistakes for fear that its regime will topple.

This attitude of false perfection severely limits Beijing’s credibility with the rest of the world, which didn’t grow up reading Beijing’s version of history and watching Beijing’s version of the news.

Beijing should not seek to promote expensive markets for no economic reason — using propaganda as a tool further disconnects stock valuations from company cash flows (which determine stock valuations in every market but China’s).

Beijing should focus the CSRC exclusively on market function — telling it to ignore market valuation — and the CSRC should actively encourage short selling, options and hedging to allow investors to express their economic views.

Beijing should allow markets to settle at whatever valuations their cash flows support and redirect its efforts into removing China’s many roadblocks to the creation of sustainable economic value.

That’s a longer, harder solution than lending people margin money and telling them to buy more stocks.

But it’s the only way China’s economy will achieve the growth rates its leaders want.

That growth — and the trust that steady profits from well-run businesses would bring — is far more valuable to China over the next five, 10, or 15 years than the loss of an artificial rally.

Beijing wants at all costs for the Chinese people to never question its control.

But if it continues to destroy trust, that’s exactly what the people will be doing.

Nobody wants to play cards in a rigged casino.

James Early is chief executive and Alex Pape, CFA, is chief investment officer of Iwaitou.

The full article appeared in the August 2015 issue of Hong Kong Economic Journal Monthly.

– Contact us at [email protected]


James Early is chief executive of Iwaitou. Alex Pape is Chief Investment Officer of the firm.

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