21 September 2019
China's stock market rally could continue for a while on the back of a benign policy environment. Photo: Bloomberg
China's stock market rally could continue for a while on the back of a benign policy environment. Photo: Bloomberg

Why the China bull run will continue

The exponential rise in Chinese stocks (which have gained more than 60 percent since late 2014), propelled by an explosion in margin trading, has raised concerns about a bubble build-up.

Indeed, one cannot dismiss the risk! That said, research shows that an asset bubble could last for any length of time, ranging from weeks to years.

At this stage, there is no evidence of China’s margin debt growing to a dangerous level that could trigger a market crash. A recent macroeconomic policy-shift by Beijing, aimed at containing the downside risk of growth, could support the market boom for a while longer.

Margin trading volume is not a reliable leading indicator for stock market crashes. For example, although an explosion in margin trading led to sharp market corrections in the US in 2000 and 2007, there were many other occasions in the past 20 years when a sharp rise in margin trading did not lead to a crash. We do not know, ex ante, when and if the level of margin debt has reached a critical level that would lead to a market crash.

A jump in overall stock market leverage is more relevant to assessing the chances a market crash in China. This often accumulates in invisible ways; margin debt is just one of them.

For example, in the 2005-2007 stock-market boom, leverage built up significantly on the balance sheets of Chinese companies, especially unlisted state-owned enterprises, which collateralized hard assets to borrow from banks and used the proceeds for stock punting. This time around, some players are borrowing through the shadow banking market.

The trouble is that we do not know exactly how and where speculative leverage is building and when the red line will be crossed until after the event (market crash). However, putting the recent A-share market boom into perspective can help to assess the nature of this bull-run.

Firstly, both the Shanghai A-share index and the number of new investor accounts opened have only reached levels that are about half their 2007 peak. The latter not only has a close correlation with the A-share movement, it also shows that only about half of the potential investible funds have entered the stock market, compared to the last bull cycle.

Secondly, despite the recent slowdown, China’s nominal GDP has grown by 3.5 times since 2005, the onset of the last stock market boom. On a macroeconomic basis, this will bolster the argument that the strong run-up in stock prices has not been entirely a bubble and that the rise in overall leverage has not all gone into stock punting.

The key issue affecting the outlook for Chinese stocks rests in the deflationary risk in the system. China’s PPI has been in deflationary territory for more than three years. Nominal GDP contracted in the first quarter of this year with the GDP deflator turning negative for the first time since the US subprime crisis. In fact, China has seen a negative output gap since 2011.

Hence, real interest rates have soared, creating a downward economic spiral by killing investment appetite, aggravating deflationary pressures and eroding investment sentiment. In the absence of any big-bang supply-side structural reform, monetary easing is the only option to break the vicious spiral in the short term.

Arguably, Beijing was slow in realizing this, as it focused on deleveraging the economy in 2014. The interest rate cuts since November last year show that it has finally recognized this risk and shifted its policy focus from cutting debt to protecting growth while cutting debt, and from containing inflation to fighting deflation.

While the rise in margin trading is a legitimate concern, the change in Beijing’s policy focus is more important in shaping the outlook for stocks.

Weak growth and deflation risk will put pressure on Beijing to adopt a policy-easing bias to reduce systemic risk. Stock valuation may be a secondary concern for Beijing at this stage, as it sees a strong stock market as a facilitator for capital market reform by reducing the reliance of corporates for bank funding.

This benign policy backdrop plus rising momentum can propel Chinese stocks further through price-multiple expansion.

Opinions here are of the author’s and do not necessarily reflect those of BNPP IP.

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Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”