Thursday, August 13, 2015

Random thoughts on China's stock market collapse

In China, red means a stock price is up

1.  The stock market was red hot ... (then it turned green) 

So hot, in fact the Chinese stock markets created US$6.5 trillions of value in just 12 months – the Shenzen Composite was up 158% year-on-year as of early June 2015.    Then it went down crashing to everybody’s hysteria and confusion – except everybody outside of China saw a massive bubble from far away.  Between June and July, Shenzen lost 40% of its market value before some multi-pronged government intervention stopped the bleeding (basically by stopping trading for half the stocks).

2.  In the beginning there was easy money

The bubble was fueled by the People’s Bank of China (PBOC) multiple rate cuts.  Four reductions in the reference rate since November 2014, as well as the RMB peg to the USD (which was just recently lifted this past week), form the pillars of the “Chinese QE” policy to boost growth.  Low interest rates were intended to drive consumption as well as investment.

Unfortunately the Chinese economy is not driven by consumption; its people are avid savers, unlike Americans who regularly max out their credit cards to buy everybody Christmas gifts, or the latest Iphones.  China’s savings rate (51% of GDP) is triple that of the US.

The Chinese used to put their life savings into bank deposits.  But after the rate cuts, bank account yields became unattractive, so they all moved on to buying property.  This worked for some time (i.e. many years), but after terrible cases of oversupply in many markets, property prices came down and the government promptly told the public that property was no longer safe haven.  So people went into the stock market in droves.

3.  China has more trading accounts than Indonesia has population(!)  

Credit Suisse estimates there are 258m trading accounts in SH and SZ stock market.

Some analysts point out that the Chinese stock markets are actually quite small (as % of GDP) compared to the markets in US/Japan, or even compared to the Chinese bond markets.  I think this is probably more telling about the sheer size of the economy, than a commentary of the stock market, which is indeed still fledgling.

Green means down

4.  About 2/3 of Chinese investors don't have a high school education

...some are even illiterate.  Inexperienced investors don’t have a clue about portfolio risk.  Even Chinese farmers were giving up tending their fields in order to tend their stocks.  Many investors are young -- about 1/3 are age 30 or below.  Uninformed investors tend to be on the hook for losses, as more experienced players readily cash out of the market.

These people entered into the stock market because the Communist Party was pushing them to buy buy buy.  As the market crashed and burned, they will likely blame the government -- which is why the government is very fearful of widespread anger and anarchy.

5.  These unsophisticated investors bought shares using borrowed funds

Margin lending skyrocketed; the official amount is RMB2.2 trillion, up five-fold in 2 years.  On top of that, there’s possibly double that amount in unofficial/unrecorded margin lending vehicles, as low interest rates and loose banking policies encouraged such loans to shady lending companies.

Margin lenders even allowed – probably encouraged – using property collateral for stock purchases.  This means is that fickle market movements could (and probably would) result in people losing their homes.

6.  Not just retail investors; even corporations drank the kool-aid

Chinese companies borrowed funds in huge amounts, with stock as collateral – exacerbating volatility.  Even junk companies that should have gone bankrupt, successfully raised capital in the market to stay afloat.

7.  Government is making an all-out effort to bail out the stock market

Because of the sheer number of retail investors, the government is risking social unrest if the stock market collapses without intervention.  Meanwhile, critics say the government’s efforts are fruitless and lacking in coordination and transparency.

8.  China doesn't have an official spokesperson, like Greenspan or Draghi, to calm the markets

Senior officials in the government, usually appointed by the Communist Party, are afraid to say something that may upset their bosses.  So investors dwell in befuddlement as prices continue to collapse.

9.  The Chinese middle class aspires to be wealthy in retirement

...even if the odds are against them.  I call it the mahjongg syndrome™, perhaps driven by the fact that it's a huge country and everybody knows “a friend of a friend” who had made it big time.  That’s why people gamble all their money, invest in junk stocks, and buy Bitcoins.

10.  Critics say the problem is more fundamental

... that the Chinese economy is hugely misdirected.  Over-reliance on investment and exports as part of GDP, wrongly-incentivized local governments, general misallocation of assets and stubbornly low consumer spending could mean the economy is stuck in a “middle income trap”.

However, this is not news; experts have argued for years whether China was about to have a hard or soft landing.

Max Fisher of Vox: " be a reliable growth engine, China must recalibrate its entire economy. This will require politically-sensitive reforms to empower small-and-medium-size companies, get off the country's addiction to exports and rein in a massive shadow-banking industry prone to creating debt bubbles."

Ah don't forget about the debt issue. Local governments have been accumulating debt at record pace, with recent estimates putting 2015's debt service burden at 1 trillion yuan (US$156bn) while revenue dwindles due to slumping property sales.  Similarly the private sector is massively indebted -- a large portion in foreign currency (i.e. USD-denominated) loans, making it highly vulnerable to painful deleveraging when the RMB devalues.  According to a 2014 report by the Conference Board:

"Private sector debt, now at almost 200 percent of GDP and up from 117 percent at the end of 2009, is still accruing at 15 percentage points per year [...] This pace of credit creation is unprecedented for China, and the result has been debt levels that are now well in excess of the thresholds that have historically triggered financial crises in other countries.”

11.  What we know for sure is that the Chinese economy is slowing down

... and it will likely start a global recession.  Ray Dalio, a prominent hedge fund manager, writes in his report that the market mayhem will hugely affect consumer spending.

The impact comes from the direct shifts in wealth and the psychological effects of the stock market bubble popping […] Though stock prices are [still] significantly higher than they were two years ago, the average investor in the stock market has lost money because more stocks were bought at higher prices than were bought at lower prices. We now estimate stock market losses in the household sector to be significant—i.e., about 2.2% of household sector income and 1.3% of GDP. However, these losses appear to be concentrated as only 8.8% of the population owns stocks. These are [only] rough estimates.[...]  [But even] those who haven’t lost money in stocks will be affected psychologically by the events, and those effects will have a depressive impact on economic activity.

As the second-largest economy in the world, a hard landing in China will have negative reverberance globally.  Demand for commodities will be adversely affected, which will impact all emerging economies who are dependent on commodity exports like Indonesia, Brazil or Argentina.  Australia, also another resource-rich country, is already bracing for a dramatic slowdown.

12.  There's still a lot of unknowns

Most experts don't believe official numbers coming out of China, so it’s hard to judge the impact in the short-term; we can only assess the complete picture after the fact, perhaps years later.  What we know is that the country is so large, that we can make any argument, no matter how non-sensical, providing China as evidence.

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