Wu Jingliang, one of China’s most influential economists, compares the Chinese stockmarket to a casino. In fact, it is worse than that. He says the Chinese sharemarket is a casino without rules. Imagine a punting environment in which gamblers don’t have to follow any rules as basic as ‘no cheating’.
The performance of the stockmarket has little bearing on the real economy. When the economy was going gangbusters and growing at double digits, the sharemarket was in a bearish mood. However, the stockmarket has doubled in the past year despite the latest crash during a time when the economy was growing at its slowest pace since the 1980s.
No one can use any rational economic models to explain what is going on in China. In May, one seasoned Chinese institutional investor said that I needed to stop thinking. “In the capital market, money is the smartest. All we need to do is to respect the market. Right now, you still need to buy even when it does not make any sense anymore.”
The irrational exuberance is particularly pronounced in ChiNext, a board for start-ups. The price-to-earnings ratio for companies listed on ChiNext is about 130, which is substantially higher than PE ratios for international peers with similar growth trajectories. Struggling companies changed their names to Chinese characters sounding like ‘O to O’ and ‘P to P’ in order to take advantage of internet mania. These gimmicky tactics paid off to the bemusement of more rational players.
So what are the drivers behind the recent long rally in Chinese sharemarket?
Margin financing (using borrowed money to buy shares) plays a big part in the recent share rally. Goldman Sachs estimates margin financing has reached 2.2 trillion yuan, or 12 per cent of the market, and 3.5 per cent of GDP – “both easily the highest in history of global stock markets”.
Before 2010, margin financing was banned in China. The China Securities Regulatory Commission approved the practice in October 2011. Investors need to have at least half million yuan in cash or stocks before they can access margin financing from their brokers.
To illustrate the importance of margin financing in the recent rally, we can go back to January this year. The stockmarket dropped 7.7 per cent, one of its worst falls after the Chinese government cracked down on some of the country’s biggest securities brokerages over margin lending. This clearly shows that the market understands how important margin lending is to buoyant share prices.
However, if the bubble bursts (some argue it has done so already), the pain would be much worse this time around than the last market crash in 2007 when margin lending was still illegal. Morgan Stanley analysts believe the odds are that it will inflict a much bigger loss on households.
China’s largely retail investor dominated market also plays a large role in the recent speculative run. Unlike other developed markets, which are dominated by large institutional investors, 90 per cent of investors in China are small ‘mum and dad’ investors, who are more prone to speculative activity.
Allegedly, inside trading tips and rumours about imminent government announcements spread like wildfire in China. During a recent trip to Beijing, I was offered a stock tip by someone who claimed to be a friend of the best friend of the wife of the deputy chairman of the China Securities Regulatory Commission. This is by no means an isolated incident: the Chinese bull market thrived on such rumours and hot tips.
Last but not least, many people suspect the government is orchestrating the latest stock rally, citing countless state media reports cheering the stockmarket as an example of Beijing’s visible hand. It is true that Beijing has been trying to revive the comatose stock market for years; it is perhaps giving too much credit to the power of the Chinese Communist Party to suggest it has the power to switch on and off the world’s largest stockmarket.
When the market turns over 3 trillion yuan in daily trading, even the powerful party will find it is next to impossible to manipulate it in a way it wants. So why does Beijing cheer on the stockmarket rally then?
Wu Xiaobao, one of China’s most respected economic writers, offers a plausible theory. He believes the government is whipping up a stock frenzy to accomplish one of its main policy goals: to recapitalise China’s cash-strapped companies and inject money into the real economy.
He describes the move as a calculated gamble on the part of government that some of investors’ money will flow into the real economy and allow some competitive companies to access cash to move up on technological and innovation ladders.
Despite the recent crash, it is still premature to conclude the bull market is over. What is clear is that Beijing does not have the appetite to deal with another major economic problem while it still struggles to contain the fallout from a slowing property market and a large build-up of debt in the country’s financial system.