July 08, 2015

China's market has lost US$3 trillion in one month but foreign institutions are not exposed but long term risks exist for China

China’s stock market has lost over $3.25 trillion in value in less than a month without creating a domino effect across the world. Chinese markets continued their plunge this week, wiping close to 37 percent off the market’s valuation from June 12 peak. The intensity of the loss can be judged from the fact that it is nearly twice the market capitalisation of all stocks traded in India and more than the Spanish, Russian, Italian, Swedish and Dutch stock markets combined.

Since June 12, the Shanghai Composite has lost an unnerving 32%. The Shenzhen market, which has more tech companies and is often compared to America's Nasdaq index, is down 41% over the same period.

Normally when one market falls, especially of the size of China, other markets follow suit. China in fact is the second biggest market in terms of market capitalisation but despite a 37 per cent fall in its value, Dow Jones, representing the largest market, is down by less than only one per cent in a month.

Why is it that China is falling in isolation?

The answer is absence of foreign institutional investors (FIIs) in the country. FIIs exposure to China is through stocks listed in Hong Kong in what is known as H shares. China prevented entry of foreign investors in its country. Reuters reports that a landmark scheme linking Hong Kong and Shanghai stock markets launched last November has failed to get much foreign participation, with concerns about stock ownership and how trades are settled dogging investors. Even MSCI (Morgan Stanley Capital International) index decided to delay inclusion of China’s A share in its list of investable shares.

According to Thomson Reuters data, foreign investors account for less than 1 percent of the mainland equity market as compared to nearly 25 per cent for India. Thanks to this limited exposure by foreign players directly in China, a contagion to other markets has been prevented.

The Economist explains the risks to China's long term financial reforms and economic development

The Shanghai Composite, the country’s main index, has fallen nearly 30% in less than a month. The sell-off of small-cap stocks, which had led the rally, has been even sharper. Chinese regulators may have more levers to pull than their peers in most countries, but even they, it turns out, are powerless to tame the alternation between exuberance and fear that makes stockmarkets yoyo. In fact, their efforts to do so may be exacerbating the volatility.



The crash has underlined the burgeoning role of debt in Chinese share-trading. Goldman Sachs reckons outstanding margin financing, at 2.2 trillion yuan ($355 billion) earlier this week, was the equivalent of 12% of the value of all freely traded shares on the market, or 3.5% of China’s GDP. Both “are easily the highest in the history of global equity markets,” its analysts noted. With Chinese shadow banks and peer-to-peer lenders also offering cash to investors, the amount of hidden leverage in the market is estimated to be as much as 50% higher.

The crash has underlined the burgeoning role of debt in Chinese share-trading. Goldman Sachs reckons outstanding margin financing, at 2.2 trillion yuan ($355 billion) earlier this week, was the equivalent of 12% of the value of all freely traded shares on the market, or 3.5% of China’s GDP. Both “are easily the highest in the history of global equity markets,” its analysts noted. With Chinese shadow banks and peer-to-peer lenders also offering cash to investors, the amount of hidden leverage in the market is estimated to be as much as 50% higher. That debt helped fuel the initial rally. It is now adding to the pain, as leveraged investors rush to sell their holdings to cover their debts.

This is uncharted territory for China. When its last stock bubble burst, in 2007, authorities had yet to allow margin financing. The presence of so much debt in the market means that the knock-on consequences of the current sell-off could be farther reaching than in 2007. Investors who borrowed to buy shares now face huge losses. Brokers have decent buffers for now after raising plenty of capital, but the current crash will start to wear them thin. Banks, in theory, are immune, in that they are not allowed to lend for stockmarket speculation. But in practice, many will have, whether knowingly or not, and so will have a new category of bad debts to worry about.

Nevertheless, the longer-term consequences of the correction are more worrying than the short-term ones. The capitalisation of China’s stockmarket when judged on a free-float basis is just about 40% of GDP, compared with more than 100% in most developed economies. There has been little evidence of a positive wealth effect (rising share prices leading to more consumption) on the way up, so there should not be much of a squeeze on spending on the way down.

In the longer term, though, the stockmarket is critical to the Chinese economy. After the 2007 crash, investors shied away from shares for years and new listings all but disappeared. A repeat of that would be very damaging for China’s development. For investors from households to pension funds, a well functioning stockmarket is essential given very low interest rates and the shortage of other ways to earn a decent return. For companies, equity financing is needed as a viable alternative to bank borrowing to reduce their reliance on debt. Share listings also demand more transparency and scrutiny of companies, which should improve corporate governance.

The biggest risk, though impossible to quantify, is that the rout will undermine China’s enthusiasm for financial reform.

Government Intervention

Here's a full rundown of the Chinsese government's extraordinary efforts in recent days:

1. The government is essentially buying stock: The CSF is lending $42 billion (260 billion yuan) to 21 brokerage firms so they can purchase "blue chip" stocks. That's on top of what the $20 billion the brokerages vowed to buy over the weekend.

2. China is even buying small stocks: The CSF also pledge to buy more small and medium-sized stocks, although there was no specific amount given of how much would be spent.

3. New stimulus: A new $40 billion (250 billion yuan) plan announced Wednesday to foster growth in areas of the economy that need it most. China's economy has been slowing down.

4. More government spending: China will also speed up infrastructure spending that the government was already planning to do such as building roads and utilities.

5. Over half of China's stocks have stopped trading: China has allowed half of the companies on the stock exchange to halt trading in their shares.

6. Big shareholders can't sell for 6 months: Starting Wednesday, controlling shareholders and board members are prohibited from reducing share holdings via the secondary market for six months. China Securities Regulatory Commission promised it would "deal with them seriously" if anyone violated that rule.

7. No more IPOs (for now): China stopped any new stock listings over the weekend.

8. Central Bank slashed rates: China's central bank has cut rates to a record low in an effort to pump more money into the system.

9. Investors have a lot of leeway now on collateral: Investors now have more options to back their margin trades. Many investors speculated on stocks -- they would borrow money to buy stock because they thought the stock would go up and they would make enough money to pay back the loan and make a profit. Chinese investors can even pledge their homes as collateral, according to Bloomberg.

10. Devaluing the yuan: China's currency has fallen heavily in July against the dollar. There's speculation in the Asian press that it will slide even further. A weaker yuan makes Chinese exports to the U.S. and elsewhere cheaper, so it should help jumpstart growth.

So far, all the Herculean efforts have failed to calm the markets. According to Bespoke Investment Group, China's stock markets have now lost $3.25 trillion. To put that in perspective, that's more than the size of France's entire stock market and about 60% of Japan's market.

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