26 October 2016
China's recent market crash showed that margin financing had gone out of control. Photo: Reuters
China's recent market crash showed that margin financing had gone out of control. Photo: Reuters

Why the deleveraging in A-shares will be good for China

Excessive leveraging in off-market margin financing is one of the key factors behind the recent equities meltdown in China.

Things were OK for speculators as long as the market was going up. But once it changed direction and share prices fell significantly, the borrowers had to liquidate their positions, causing prices to slide even further.

The dramatic market crash showed that margin financing had gone out of control.

The China Securities Regulatory Commission had been aware of the problem. Hence, it began cracking down on off-market margin financing on June 16, when the Shanghai Composite Index hit a high of 5,166 points.

Now, in the wake of the steep slide in equity prices, highly-leveraged investors have been forced out from the market.

The de-leveraging process is likely to continue in the short term.

Stocks have stabilized for now following a series of emergency measures by Chinese authorities, but the lessons should not be forgotten from the recent crash.

Chinese investors love speculation, and they treat the stock market as a casino. The mindset has never changed over the years. Meanwhile, equity valuations were far removed from the real economy.

Frankly speaking, the government should take some of the blame for the problematic stock market. No government official has stood up and warned investors during the market run-up that a leverage-driven market bubble may not sustain for long and that it will burst sooner or later.

Retail investors have suffered the most during the market meltdown. Big investors or institutional players usually hedge their investments or make an early exit. By contrast, retail investors cannot afford expensive hedging tools like stock index futures.

It’s commonly believed that the government will step in to bail out if there is any crisis in the market. This perception should not be encouraged as government interference will only hamper the healthy development of the market in the long run.

The government should instead focus on providing a fair playing field for investors and establish effective information disclosure and introduce hedging derivatives.

The market crash has proved that liquidity has not flowed into the real economy. Now, everyone should ponder whether market prosperity can be sustained without support from fundamentals.

The stock market should have a correlation with the real economy, and serve genuine investors and corporates rather than only speculators.

China should be able to maintain 7 percent growth, based on current economic data. However, it’s rather worrying that private investors may shrink in number following the market meltdown.

The nation’s economy may continue to face downward pressure in the next one to two years. Household consumption and investment activities by small and medium-sized companies may be affected due to the losses in the stock market.

This article appeared in the Hong Kong Economic Journal on July 14.

Translation by Julie Zhu

[Chinese version中文版]

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adjunct professor in the Department of Finance at HKUST Business School

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