17 July 2019
A trading hall is left empty after the early end of trading triggered by the new "circuit breaker" mechanism. Photo: Xinhua
A trading hall is left empty after the early end of trading triggered by the new "circuit breaker" mechanism. Photo: Xinhua

What we missed while watching China’s stock market mayhem

China’s stock market hemorrhage last week had people talking about the “circuit breaker” mechanism that allowed trading to be halted to prevent further bloodshed.

Few bothered to look at the economy’s L-shaped growth which is set to be the new normal.

This will have far-reaching impact on the equity markets on both sides of the border.

Market expectations of a “V-shaped” rebound on the back of short-term stimulus have all but dissipated.

Beijing is determined to tackle excess capacity, already a tough job, which means the stock market could dip further before it picks up.

“We have to resolve some longstanding structural issues, which are reflected in the falling economic growth rate, industrial product prices, company earnings and fiscal revenue growth and rising economic risks,” the Chinese authorities explained in a People’s Daily article on Jan. 5

“These are not seasonal but structural problems.”

The economy could stall as it goes through a painful restructuring.

And in order to achieve sustainable growth, the government must weed out low-quality and highly polluting and energy-consuming capacity.

The macroeconomy will follow an “L-shaped” trajectory before it can see its growth engine humming again.

The government is betting on an ambitions tech-driven strategy, called Internet Plus, as well as a host of innovative measures such as environmental protection and energy conservation.

A cycle of destocking, deleveraging, eliminating excess capacity and cost cutting is expected to continue into the future.

The economy is already under mounting pressure so early in the new year and corporate earnings could worsen further.

Some companies in traditional industries might go out of business after struggling for years.

So-called “supply-side reform” will exert further destocking pressure on traditional sectors, narrowing the time window for businesses.

A number of “zombie companies” have considerably stretched the fiscal capability of local governments and undermined the finances of entrepreneurs.

While new emerging industries have seen rapid growth thanks to rising consumption and innovation, they have yet to fill a void in the traditional sector.

The recent Central Economic Work Conference underscored the need to crack down on overcapacity and ramp up structural reform, bankruptcies and re-employment.

“Persistent overcapacity would further drag industrial product prices, which would in turn weigh on company earnings and derail broad economic growth,” the article said.

“Substantial capacity was built up during robust economic growth at home and abroad. Some of this capacity have expanded further in response to the global financial crisis. However, mere stimulus can’t fix overcapacity amid moderating growth worldwide.”

Already, there are signs of contradiction between “restructuring” and “stabilizing growth”.

For example, large-scale tax cuts go against Beijing’s goal to crank up fiscal spending and the 6.5 percent growth target is inconsistent with the aim to eliminate excess capacity.

If Beijing is willing to push forward supply-side reform in exchange for a certain growth target, the equity market might be out of the woods quickly.

Historically, easy monetary policy and strong corporate earnings are two main catalysts for China’s A shares.

These two forces take turns.

The bull market in 2001 was driven by monetary easing while that of 2007 resulted from economic and earnings growth.

Monetary easing again led to a bull market in 2014 and 2015. The next market boom depends on company earnings.

China needs sweeping structural reform to solve longstanding economic issues and there is bound to be pain throughout the process.

Meanwhile, local governments have revised their evaluation system from the gross domestic product growth model of the past.

Still, the central government has to ensure the bottom-line growth rate of 6.5 percent.

The future of China’s economic restructuring hinges on key reform in the state enterprise sector, financial market and and fiscal policies.

This article appeared in the Hong Kong Economic Journal on Jan. 11.

Translation by Julie Zhu

[Chinese version 中文版]

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Senior investment banker

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