Despite a rebound from recent falls, trading in 19 percent of shares was suspended prior to this week. During Monday’s 8.5-percent plunge, market rules automatically halted trading in an additional 35 percent.
If China wishes to achieve its goal of welcoming more international investment, it should limit any further intervention.
The remarkable bull run in the Chinese stock market over the last year was partially supported by the “government put.” Since last November, the People’s Bank of China has cut interest rates by 1.15 percentage points and reserve ratio requirements for banks by 1.5 percentage points. This helped engineer a 150 percent rally in the Shanghai Composite equity index from the second half of 2014 until June 12 this year. It was widely assumed that since the government wanted a booming market, downside risks were limited.
The slump of 30 percent peak-to-trough since then suggests otherwise. However, considering onshore Chinese stocks have experienced average annualized volatility of around 30 percent in 2015, the recent sharp correction should not be completely surprising. After all, even at their trough, Shanghai and Shenzhen-listed A shares were still up 4 percent over the year to date and a remarkable 69 percent since the second half of last year. Why has the government been so frantically trying to stop the correction?
One possible explanation would be systemic risk in the financial system. Banks may be vulnerable to equity-market selloffs through their exposure to loans collateralized using stocks. Brokerage firms can also incur margin losses as margin financing roughly quintupled over the past year to 2.2 trillion yuan as of the end of June. However, we believe the systemic risks for the financial sector are rather low. The highest market estimate of potential bank exposure stands at 2 trillion yuan, far lower than banks’ total balance sheets of 180 trillion yuan.
Another worry could be the effect on consumption and the economy. Maybe Chinese authorities see weaker activity than official data suggests. Even then, if you include real estate, only about 10 percent of Chinese household wealth is in stocks. In addition, there is no historical correlation between Chinese stock-market performance and retail sales. Furthermore, purchasing managers’ indices, leading economic indicators, have stabilized in the last couple of months, and policy easing should help revive the economy later this year. We expect two more interest-rate cuts over the next 12 months and potentially another cut to reserve-ratio requirements.
The real reason for the government’s worry is maybe a combination of the above concerns. But the way the authorities have tried to reverse the market slide so far will have medium-term consequences. If the correction thus far were to threaten the economy, which does not seem likely, it would be preferable to implement broad-based measures such as interest-rate cuts or to create a stabilization fund to buy the market using the government’s vast financial resources. Supporting the market with broader measures would create fewer distortions than, say, suspending initial public offerings or trading in certain shares altogether.
Quantitative restrictions on the supply of stocks and unpredictable changes in margin requirements for retail accounts have fueled more panic and may have contributed to spread the contagion to Hong Kong and other parts of Asia. More importantly, many of these measures are a step back from the reform agenda promised in 2013 and likely move the Chinese onshore stock market farther away from its inclusion in international investing benchmarks.
The suspension of IPOs also goes against the government’s plan for corporate deleveraging. Companies hoping to raise equity capital to reduce their debt may now face liquidity issues. The Chinese bond market is feeling the pinch. The difference between the yield on U.S. Treasurys and companies in the JPMorgan Corporate Emerging Markets Bond Index China has widened by roughly 0.2 percentage points since the trough in late June.
Deng Xiaoping, as translated by author Henry Mok, said of the Chinese equity markets: “We conducted some experiments on stocks in Shanghai and Shenzhen, and the result has proven a success. Therefore, certain aspects of capitalism can be adopted by socialism.”
Intervention in the stock market recently has proved that this selective approach to capitalism lives on in China. If the country wants to attract more international investment, it may have to improve its tolerance for free market gyrations.
Commentary by Jorge Mariscal, the emerging markets chief investment officer at UBS Wealth Management, which oversees $ 1 trillion in invested assets. Follow UBS on Twitter @UBS.