China’s bull market isn’t finished yet, despite the wild ride

G. Bin Zhao says the ride may be scarier than expected, but this crash isn’t the end of China’s bull market

PUBLISHED : Wednesday, 08 July, 2015, 5:41pm
UPDATED : Friday, 28 October, 2016, 9:12am

If you have never  ridden a roller coaster at a theme park, perhaps because you worry your heart might not take all the excitement, then the thrills and chills of buying Chinese stocks may not be for you.

There has been severe turbulence in the Shanghai and Shenzhen markets over the past three to six months, very rare occurrences in the short 25-year history of the Chinese capital market, and international investors are stunned. What has caused this phenomenon, and what should be done to prevent the sudden surges and 8declines in the future?

First, it is generally known that the recent round of rapid rises in the stock market lacks fundamental economic support. China’s macroeconomic growth rate has hit a record low of 7 per cent, and the stock market, after a seven-year bear market that persisted since 2008, started its gradual recovery in the second half of last year, and 8increased dramatically this year. This phenomenon contradicts the basic principles whereby the stock market acts as a barometer for the economy. So, in the absence of both strong macroeconomic support and profitability among a majority of Chinese companies, the rapid growth of the market in such a very short period planted the seeds for disaster.

Of course, the Chinese market is still developing, and historically, its ups and downs have rarely followed any economic laws. This has made it difficult for it to become a channel for investors to share the fruits of  growth in recent years.

Second, margin trading and short selling, namely leveraged trading, which started in 2010, boosted  uncertainty in the market. During the  downturn, it was uncommon for stocks to be bought and sold through leveraged trading, but once the bull market seemed certain, investors gradually increased this trading method. The amount of funds used for leveraged trading through formal and legal channels such as securities and fund companies is estimated at about 2.3 trillion yuan (HK$2.9 trillion).

Obviously, compared with the total floating value of about 40 trillion yuan in the Shanghai and Shenzhen markets, this 2 trillion yuan, which accounted for about 5 per cent of current total tradeable market capitalisation, may have great influence on market swings, but will not quickly change the entire market in the short term.

Third, one of the major reasons, or the core factor, that has resulted in the current turbulence  is that a large number of individual investors buy and sell stocks by financing five to 10 times the value of their own funds. Since the start of the stock market recovery late last year, many investors, believing the bull market and high returns were just around the corner, borrowed money through different channels to invest. Thus, the entire stock market was transformed into a margin trading mechanism similar to a futures market. For example, investor C has one million yuan for stocks, and he uses this as margin to finance five to 10 million yuan from friends, banks or other sources. Their agreement may stipulate that if they make money, they will share the earnings according to certain percentages; but if they start to lose money,  the fixed limit  is only one million yuan. When the market declines, if 8investor C is 8financed  at a ratio of 10:1, a 10 per cent drop means he has lost his one million yuan; 8according to the agreement with his lenders, he must sell all his stocks to stop the loss. Such sell-offs are a major reason for the continuous fall in the market over such a short time.

Previous funds invested in the stock market had been relatively limited, but many greedy individual investors, betting that the bull market had finally arrived, borrowed to invest without understanding or fearing the risks. As a result, a lot of money flooded the market, causing it to rise sharply.

This financing usually takes the form of individual loans. There is no risk for the lenders, and the loan participants include not only individuals, but also banks and businesses, so the size of the funding can be very large. According to 8expert estimates, the amount is 8between five trillion and 10 trillion yuan, but because it is hard to get complete information about these loans, it is difficult to determine a more exact total, so the full amount is still debatable.

In short, the Chinese stock market is like a futures market because of massive leveraged trading, and many participants are individuals  who lack  expertise or training. That is the main reason for this crash.

Thankfully, the roller coaster seems to have come to the second half of the ride. Although we cannot predict what will happen next, we must believe in the philosophy of value investing. Bubbles do not 8often persist, and investigating and resolving the reasons  they formed is the key for the long-term development of the market.

The regulators who promoted margin trading and short selling 8intended to boost stocks out of the bear market as soon as possible, but to their great surprise,  many 8individual investors got involved in leveraged transactions through 8informal channels. The market was a mess within a few months.

Institutional investors should be forced to deleverage, and stricter regulations put in place, but the effects of these initiatives may be limited. More large-scale private investment involved in leveraged lending is hard to 8define and hard to control. One effective measure would be to require banks and other institutions to  monitor the use of funds to prevent them  flowing into the market. In addition, if applicable, legal means must be considered to combat third-party service providers who arrange financing for individuals.  

In the interim, when the development of the entire national economy is slowing, overall economic and financial stability is crucial. Sharp changes in the stock market may lead to  other risks, which shouldn’t be overlooked. Some have criticised the central government for its multiple bailouts, but I believe policy interventions are  necessary until mature market mechanisms  are formed.

Turbulence in the stock market will hit investor confidence in the short term, volatility will probably continue for some time, but the bull market is not over yet; the prelude was just a bit more thrilling than expected. China is suffering a slowdown, but its economy is still thriving compared with others’,  and so is  its stock market.

G. Bin Zhao is co-founder of Gateway International Group, a global China consulting firm, and executive editor at China’s Economy & Policy