China market rout predictable, say analysts, see more pain ahead
The collapse in China’s A-share market was predictable, the government’s responses are unlikely to prevent further losses and a financial crisis is not out of the question, analysts say.
The central government has urged people to buy stocks since late last year, creating a bull market which it believed would help achieve financial liberalisation, debt deleveraging and state-owned enterprise reforms, according to reports issued by Bank of America Merrill Lynch and AXA Investment Managers.
Investors bought in enthusiastically, but the dream was rudely interrupted when the markets began to tumble. Since June 12, the Shanghai and Shenzhen composite indices have plummeted around 30 per cent and 40 per cent respectively.
Policymakers are very concerned about the selloff and are determined to stabilise market conditions
“The rollercoaster ride of the A-share market has much to do with the dramatic expansion and the subsequent unwind of equity market leverage,” said Aidan Yao, senior emerging market economist at AXA.
According to AXA, leverage amounted to 3.3 trillion yuan (HK$4.1 trillion), including 2.5 trillion in on-exchange margin financing and return-swap products and 800 billion yuan in off-exchange borrowing from financial institutions.
Bank of America Merrill Lynch said Beijing did not foresee the crash because it did not realise the full extent of shadow margin financing.
Since the crash, the government has announced measure after measure to halt the free fall, beginning with interest rate cuts, postponement of initial public offerings and suspension of new listings. It then declared 21 major brokerages would invest 120 billion yuan in blue chips and index exchange-traded funds, while 25 mutual funds would buy and hold futures.
“The continued flow of market support measures over the past three weeks … suggests the policymakers are very concerned about the selloff and are determined to stabilise market conditions,” Yao said.
Perhaps most significantly, the People’s Bank of China announced it would provide liquidity support to the China Security Finance Corporation (CSFC), which oversees the margin financing of brokers. For some, this raised the prospect of the central bank intervening through the CSFC to bail out the market. But Yao said he believed there were limits.
“[We] take a more circumspect view on the People’s Bank of China’s intention here, and believe that the central bank would not want to risk its balance sheet and credibility by fully committing itself to an equity market bailout,” he said.
Other analysts were unimpressed by the government’s response as markets continued to dive.
“So far, government measures have appeared to us to be behind the curve,” Bank of America Merrill Lynch said. “We believe that the biggest damage caused by the A-share market’s roller-coaster ride since the middle of last year has been to investors’ faith in the government’s ability to manage asset prices reasonably smoothly.”
David Goldman, managing director of Reorient Group, agreed. “The People’s Bank of China appears to be flailing in response to events,” he said in another report.
A one-third plunge in less than a month is no picnic, but AXA said it was particularly dangerous considering the mainland markets’ tendency to overshoot. Bank of America Merrill Lynch said extended falls could see stock lending related losses run into trillions of yuan, much of it likely to borne by banks and brokers.
“We had always considered the risk of a financial crisis in China as high,” the Bank of America Merrill Lynch report said. “What has happened in the stock market has likely increased the risks considerably and also brought forward the timeline by our assessment – the leverage is much higher now and [the] economic growth rate potentially lower.”
AXA agreed. “Continued collapse of the market, as we saw in recent weeks, could quickly degenerate into a full-blown crisis,” Yao said. “Once the damage is done, the equity market could take years to recover – a length of time China cannot afford to lose for its structural transformation.”
Bank of America Merrill Lynch said likely consequences of the crash included distortion of credit flows as financial institutions turned cautious, lower pricing of assets going forward, slower growth and poorer corporate earnings.
The mainland’s 90 million retail investors, who fuelled much of the market growth this year, are unlikely to enjoy the fruits of any recovery.
“The net result of this volatile market is a transfer of wealth from the people on the street to the wealthy, including many major shareholders, who cashed out,” Bank of America Merrill Lynch said. “We expect this will likely hurt consumption down the road.”
Goldman argued that the People’s Bank of China should deploy monetary easing to boost the domestic economy, in particular by allowing the yuan to depreciate against the strengthening US dollar, although he said this was not a substitute for structural reform.
“The People’s Bank of China doesn’t need to [step in and rescue] stock prices, but it does need to adjust monetary policy to economic reality,” he said.
Meanwhile, AXA signalled its belief that the crash was not over by recommending that investors continue to underweight A-shares.
