China's surging stocks: why the bull-run days are numbered

China appears to be stoking a massive stock bubble to numb the pain from the property bubble bursting and also stave off the necessary economic restructuring. It will work for a short period of time, by diverting the attention of the masses and the elite towards a massive gambling game and away from the reality. But, the bubble won't last through 2015. When the market crashes, the pain will only double.

Last weekend, government policy towards the stock market bubble zigzagged. The China Securities Regulatory Commission, the market regulator, tightened the rules for margin financing after the market closed on the Friday. The overseas markets reacted violently, knowing that the surging leverage was the fuel for the A-share market's doubling in a few months. The central bank reacted by cutting by one percentage point the required reserve ratio for bank deposits before Monday's market opening, obviously trying to reverse the crash in speculative sentiment. While China's A-share market has gone from bubble to burst many times, it is unprecedented that major government agencies are explicitly targeting the market through policy actions.

A bubble usually happens when investors overstretch the good news in a bull market. For example, the A-share market began to rise in 2005 and had tripled by the beginning of 2007. That run was justified by rising corporate earnings, an appreciating currency and strong GDP growth. The bubble occurred when naive retail investors assumed that the trend would continue indefinitely.

The current A-share bubble has negative fundamentals. Corporate earnings are on a long ride down, as the bursting property bubble triggers a prolonged period of deflation. The economy is on the way down for the same reason. Most importantly, no meaningful policy measures have been implemented to rebalance the economy. Essentially, the end of the tunnel is far away. The bubble has occurred only due to the technical and liquidity measures that seem to have been designed to stoke it.

It began with the Shanghai-Hong Kong stock through-train, which was essentially the same as combining the Qualified Domestic Institutional Investor scheme and the Qualified Foreign Institutional Investor programme, neither of which was fully utilised. But, it was marketed as an opportunity to front-run foreign investors. As the story failed to pan out, measures for boosting margin financing were unveiled, essentially to subsidise speculation with bank loans. More than two trillion yuan (HK$2.5 trillion) of loans have flowed into the market, doubling the index.

But, when the market is pumped up by loans, any correction will mushroom into a collapse, as brokers have to liquidate when the money is nearly exhausted. The central bank's recent policy action should be viewed in this context. Many speculators have leveraged 70-80 per cent of their total portfolio value. If the market dropped quickly by 20 per cent, it would go into free-fall territory.

What's the end game? Chinese speculators work on the "bigger fool" theory. The biggest fools are supposedly the " damas", China's legion of middle-aged housewives. But they lost everything in the 2007-08 crash. How to suck them back in is the challenge. The policy that allows individuals to open several brokerage accounts should be seen in this context. It will certainly create the impression of an avalanche of newcomers into the market. One basic dama psychology is safety in numbers. The impression of everyone jumping in could become self-fulfilling.