The sharp and sudden plunge scared everyone. Can the Chinese government get control of the market?
The dramatic plunge of Chinese stocks came as a shock to many who had borrowed money to invest and get their piece of the Chinese Dream. The government jumped in to bolster the market, but will it work? Economist He Fan, the deputy director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences and a Senior Economics Fellow at the Institute for New Economic Thinking, sheds light on what’s happening, why the situation is dangerous, and why you should care.
Lynn Parramore: The transformative market reforms in China have been exciting to watch, but the stock market just recently exploded. What exactly happened?
He Fan: We’ve recently seen a sharp increase of stock prices in China. In Shanghai, the share price index has increased by more than 135 percent within just a year. In Shanghai, large companies are listed in the stock market, but we also have a market in Shenzhen, where many private companies, especially new start-ups, are listed, and there the price increase has been even more dramatic — something like a 180 percent within one year.
To my knowledge, we have not seen that before, either in China or in other markets around the world. This is probably unprecedented.
The sharp increase in share prices hasn’t gone hand in hand with the fundamentals, which is unusual. For the last quarter of 2014, the GDP growth rate was 7.4 percent. Then for the first and second quarter this year it dropped to 7 percent, and that’s the lowest level after the global financial crisis in China. That’s why you often hear people in China talking about the “new normal.”
One implication of this new normal is a low potential growth rate and at the same time you see the profitability of Chinese companies squeezed. So at the micro-level, the performance of Chinese companies is not very good. I think it’s fair to say we’ve got a bubble, so the market sentiment tends to irrational exuberance and then panic. That’s happened in the first week in July.
LP: What was the trigger for the sudden drop?
HF: I think the trigger was the actions of the Security Supervision Committee — that’s the regulatory body of China’s stock market. They are afraid of the margin financing that has been happening in China, so they tried to put a tighter regulation on it. That triggered the burst of the bubble.
LP: Let’s talk about this practice of margin financing, where people are able to borrow money to invest in the stock market. Why did the Chinese government encourage it?
HF: The background for all this is the global financial crisis. In the U.S. and Europe, you saw the corporate sector and households deleveraging. But the situation in China was just the opposite. We had a very sharp increase of leverage ratio for the corporate sector and also for the government, especially the local government. That’s not sustainable, so the government had to force the corporate sector and also the local government to deleverage, which is a painful and very slow process. This further increases the downside risk for the Chinese economy.So the government is thinking, how can we offset the impact of this deleveraging?
China’s stock market, compared to that in the U.S., is underdeveloped. When people bought shares in the past, they would use their own money — they couldn’t borrow money from the bank. If you were an investor in a company in the past, you would have this stock share and there’s nothing you can do with it. Well, the government thinks, maybe we can allow the company to use the share as collateral and then it can borrow more money from the commercial banks. In this way, maybe you can increase investment and boost the economic growth. By allowing that borrowing, you can increase the trade volume and also boost the confidence of the market. With the increase in the share prices, households will have more wealth. To some extent, you can offset the painful process of deleveraging of the local government and the corporate sector.
So I think that’s what the government was thinking when they encouraged the margin financing. The leverage ratio of the margin financing I’ve described is not that serious, but we have other indirect ways of margin financing.For example, we have the so-called umbrella trust, which is a financial vehicle that allows for more leverage. Initially it’s only the bank’s money, but then they will add more from other investors. So the commercial bank will put in 100 yuan, and then finally it will expand it to 300 or 500 yuan, depending on what leverage ratio you are using.
Bottom line: Nobody knows exactly how big the margin financing has become.
LP: Would you say the size is dangerous?
HF: Yes. According to market estimates is could be as high as 5 trillion yuan and that’s definitely is already out of control. I think that’s one reason why this market crash was so serious compared to the past. China has had crashes before but not like this time, very sharp and very sudden.
LP: Everybody is talking about the Chinese government’s massive intervention bolster the stock market. How much control does it really have?
HF: They can avoid the panic in the market, but it would be very difficult to control the volatility. The reason they are doing market intervention is because they fear that the stock market crash could lead to, say, the rapid increase of non-performing loans of commercial banks. Because the commercial banks’ share is the largest share of China’s financial system, this could trigger a full-fledged financial crisis.
The Chinese government is quite unique. It has a lot of room to maneuver and officials use all kinds of policy tools, including some administrative measures. If they think they want to stop the panic, it’s fair to say that they can do that. But the problem is that right now they are in a very difficult situation. The government already injected a lot of money to pump up the stock market. So what’s the next step? It’s a dilemma. Either you continue to inject more money to pump up the stock market and you create another bubble, or you have to think of an exit from the market intervention. But once you send out the exit signal, then you get people shorting shares and prices will fall. Either way, you can’t control permanently or constantly.
LP: It’s interesting that China really doesn’t have a bond market, which leaves fewer options for where people can put their money. Why is this?
HF: The story goes back to the 1980s when China first designed the reform of the financial system. Previously, the only place Chinese people could put money was in bank deposits. Then, in the 1980s, the policy makers are thinking of developing other financial markets, including the bond market and stock market. But in the 1980s there was a very serious debt crisis in Latin America. I think that China learned the lesson from that that the bond market is a bad thing.
When they first introduced the stock market, the main purpose was not to introduce a lot of investors, but rather to facilitate the reform of state-owned enterprises. You’d have a so-called mixed economy and this way you could increase the efficiency of those state-owned companies.
By hindsight you may argue that you should have the bond market first and there are disadvantages to China’s sequence, but you can’t change history.
In the 1980s, rampant inflation taught Chinese people who had been putting money in bank deposits a painful lesson, so now even retired people will avoid them. There are only two other places to put your money.You can buy your own house —and Chinese people are crazy about buying houses. But then we have regulation on the housing market because the government is worrying about the bubble in housing prices in large cities like Beijing and Shanghai. So now the only opportunity left for ordinary people is to invest in the stock market.
LP: It looked like the stock market boom was an important step in expanding the Chinese middle class. Where does that effort now sit?
HF: The impact on ordinary people is marginal so far. Just think of the rapid increase in the stock market in the last year. A lot of people have seen profits, even with the plunge. But the worst impact is going to be on the younger generation and on those people who are not experienced in the stock market. Some of the young people may lose money because they tend to enter the market later when there’s already a bubble. So it’s a problem for the latecomers. But a lot of Chinese investors have the understanding that if you invest in the stock market, the performance may not be related to the fundamentals. It’s like if you’re in a casino — you have to be realistic that there is some possibility that you will win, but the chances are also equal that you will lose your money.
LP: Given that there’s a chance of losing, is there a conversation happening around the need for social safety nets?
HF: Not yet, because the situation hasn’t become that bad. Chinese people are eager to invest in the stock market and buy houses rather than just spend the money because China does not have a well-functioning social security net — people will only feel okay to consume if they have a safety net. The government is gradually moving in that direction and increasing the investment in the social safety net, but that’s not for the middle-income class. It’s mostly for poor people in urban areas and for the migrant workers. The middle –income class has something in the way of a social safety net, but not enough. They have to rely on themselves.
LP: Is it problematic to rely so much on buying stocks to build the middle class?
HF: The problem is not buying into the stock market or not. In China, like other places, the vast majority of income for middle class people is coming from salaries — income earned from labor. But then, gradually, they can have some savings, so they will have to find some investment opportunity.
In China, the problem is that you can’t survive if you are a value investor. The best form of investment by the middle-income class is when an investor can identify which companies are good and which are bad. Then you can have long-term investment and wait for the growth of that company which will produce dividends. But in China the only way that you can get profit from the stock market is to wait until the stock market increases. The Chinese companies — the state-owned companies and the private enterprises — are reluctant to give dividends to shareholders. So there’s a lot of distortion and misallocation. The stock market is basically for speculators, not for value investors.
LP: What’s to prevent another crash?
HF: Not only do we need to be more cautious about the margin financing, but also the very structure of the stock market. In what way do you encourage the good companies so that they can send signals to potential investors? That’s the most important thing.
LP: Why should people outside of China care about what’s happening with China’s stock market?
HF: We are living in the era of globalization. We can see that the Chinese economy is fully integrated into the world economy. The stock market crash in China sent a signal that something is going wrong in the Chinese economy. Fundamentally, the economy is still just so-so. It’s not that bad. It’s moving downward, but it’s still manageable. However, the financial market is very fragile and very volatile. If a crash like this happened again and the Chinese government didn’t stop it, and then you have, say, a new round of crises with Greece and the euro, all this could trigger a systemic crisis that could gradually become global.
