What's the true risk behind the A-share market rout?

July 17, 2015 11:45
The three-week market correction was too short to have any impact on consumption. Photo: Reuters

The 32 percent correction in the Shanghai Composite Index between June 12 and July 8 is not a harbinger for a financial crisis in China, as some have fear. It will not have a major impact on China’s GDP growth and the renminbi exchange rate.

The true risk of the sell-off lies in delaying the process of capital account liberalization and financial reform. But it also serves as a wake-up call for Beijing to re-think its structural reform strategy.

It is noteworthy that the Shanghai 50 Index (which comprises large cap stocks, dominated by banks, that foreign investors would be most interested in owning) and Chinese bank stocks outperformed significantly the broader Shanghai Composite Index in the three-week market crash.

Usually when margin debt financed a stock bubble, financials should have led the boom/bust dynamics. But this was not the case in China.

Large cap and bank stocks underperformed the broad market when the bubble was inflated, but outperformed it when the bubble was burst.

This suggests that the market’s boom-bust was not a result of financial flaws but rather of some bubbly dynamics. If there was an impending financial crisis, bank stocks would not be spared in the sell-off.

There is little risk of the market correction hurting GDP growth because of the absence of wealth effect on consumption and corporate funding.

Fundamentally, the wealth effect on consumption is based on the permanent income hypothesis, which argues that households plan their consumption and saving behavior based on their life-cycle income but not on short-term fluctuation in income.

The three-week market correction was too short to have any impact on consumption. In fact, data shows that retail sales (a proxy to consumption) in China do not correlate much with A shares’ performance.

This is also because equities have a small share in household wealth, accounting for less than 6 percent. Even if we include wealth management products (WMPs), which invest in equities and other asset classes, total equity exposure of Chinese households account for less than 12 percent of their wealth.

Further, the swift correction represented mostly wealth transfer between the winners and losers, but not a permanent destruction of wealth or future income stream. Even after the 32 percent correction, the Shanghai index is still up 122 percent from June 2014.

The impact of the market sell-off on corporate funding is also small, as equity financing accounts for only 4 percent of total social financing in the system, despite Beijing’s effort to reduce the reliance of the economy on bank loans and to increase the source of funds from equity financing.

Banks have indirect exposure to the stock market via lending to, and purchasing of WMPs from, trust and securities companies, which have extended margin financing to the stock market and lending to listed companies which put up their shares as collateral.

But the total value of these loans is estimated at less than 3 percent of total bank assets, implying a small impact on banks from stock market volatility.

In a nutshell, systemic risk is manageable.

The sharp stock sell-off has prompted some market players to forecast as much as 10 percent fall in the renminbi exchange rate in the coming year. This view is based on the unrealistic assumption of free capital outflow from China, which is not going to happen unless Beijing opens up the capital account suddenly.

China’s total external surplus is still large at over 4 percent of GDP, with the current account surplus rising again. Together with a stable exchange-rate policy, this surplus will underpin the renminbi in the medium term.

The true risk of the market rout lies in the slowing down of China’s economic liberalization, including capital account opening. The market volatility and suspension of IPOs will impede M&A and capital raising activities, delaying privatization and implementation of mixed-ownership reform of state companies and deleveraging plans of local governments.

Beijing may also reduce its tolerance for financial innovation, like margin financing, which is essential for capital market reform.

The stock market saga has revealed Beijing’s old habit of micro intervention, hurting its reform credibility and raising doubts about whether it is ready to let market forces run.

Crucially, as China continues to open the capital account, it will eventually be impossible for Beijing to have control over both the exchange rate and the interest rate.

It will have to give up control over one of the policy levers, and will have to do a lot of structural reforms to prepare China for handling economic volatility stemming from free capital flows and the loss of a monetary lever.

However, the market rout has revealed the inherent regulatory and implementation vulnerabilities in the system and has hurt Beijing’s confidence in liberalizing the capital account by opening up to market forces.

On one hand, this could make Beijing more risk-averse and slow down the pace of capital account opening. On the other hand, this should serve as a wake-up call for it to review its structural reforms strategy.

The opinions expressed here are of the author’s and do not necessarily reflect BNPP IP’s.

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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”