22 January 2019
Chinese households still hold only about 5 percent of their total assets in stocks. Photo: Bloomberg
Chinese households still hold only about 5 percent of their total assets in stocks. Photo: Bloomberg

What have the China ‘bubble’ advocates missed?

There is no doubt that bubbly conditions exist in the A-share market.

However, the view that the rapid run-up in Chinese stock prices since mid-2014 has been mostly driven by liquidity and hype ignores the importance of a strong stock market in advancing Beijing’s financial reforms, in particular by channeling more household savings into equities and, hence, reducing firms’ reliance on banks for funding and shifting the burden to the equity market.

A successful switch could lead to a fundamental rerating of Chinese equities in the long-term.

Encouraging a robust market sentiment helps Beijing to achieve several policy objectives, including restructuring local government debt, reforming the state sector, liberalizing the capital markets, internationalizing the renminbi, rebalancing the economy toward consumption-led growth and lowering the cost of funding (via equity financing) for the private sector.

Worries about a stock market bubble propelled by margin financing are exaggerated.

Despite the exponential rise in A shares, the market capitalization is still only about 70 percent of the country’s gross domestic product.

This degree of equitisation of the economy is far below the 90 percent in South Korea and 150 percent in the United States, for example.

Further, despite recent concerns about margin trading, it only accounted for less than 20 percent of China’s monthly equity market turnover in the first quarter of this year.

This is much lower than the 31 percent recorded in South Korea and almost 40 percent in Taiwan.

And the Chinese authorities are not allowing margin trading to expand out of control; they have tightened up margin trading rules twice in the last five months and will not hesitate to tighten them again if needed.

The sharp rise in the prices of A shares also reflects the rapid growth of China’s nominal GDP, which has expanded by more than 350 percent since 2005, the year before the onset of the last A-share rally.

Beijing’s financial liberalization process is likely to encourage more households to reallocate assets to stocks, creating a benign backdrop for boosting stock valuations over the longer term.

In China, the benefit of a strong stock market does not come from the wealth effect on consumption, as China’s marginal propensity to consume is very low, and Chinese households hold only about 5 percent of their total assets in stocks.

Rather, the gain mainly comes from the reduction of the cost of equity financing, which should help ease the financial constraints on small and medium-sized (private-sector) companies.

Improving valuations typically facilitate corporate financing through initial public offerings and secondary placements.

From a macroeconomic perspective, corporate debt-to-equity ratios should fall, reducing the economy’s reliance on debt financing (including bank loans) and, thus, lessening overall economic risk.

Equity financing in China has ample room to grow, as it only accounts for about 3 percent of new aggregate (or total social) financing flows.

Of course, it is not always smooth sailing for reform, and there are also risk implications from the bull market.

Despite the still manageable size, rising margin debt is a potential risk, because it links the banking system to stock market volatility.

To fund their loans to stock investors, brokers have borrowed in the interbank market.

Any stock market volatility causing investors to default on margin loans will create a contagion effect on the banking system that is likely to be bigger than in previous cycles, as the system is now more exposed to the brokerage industry.

A more subtle risk is companies diverting capital into stock market speculation, using hard assets as collateral and borrowing from banks.

With companies struggling to generate returns from their core business in an economy where growth is slowing, stock punting may become an attractive alternative in a rising market.

This makes corporate profits more dependent on the stock market’s fortunes, thus increasing the volatility of earnings.

If the market reverses and the economy remains weak, earnings could suffer a double blow.

However, Beijing seems to believe that these risks are within controllable limits and are of secondary concern.

Its primary agenda is for a strong stock market to facilitate structural reforms and revive the “animal spirits” in the private sector so as to sustain a reasonable level of growth.

Opinions here are 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”

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