GAVIN WENDT: There are a lot of instant experts that have appeared over recent weeks that are prepared to espouse all sorts of doom-and-gloom commentary with respect to China’s economic outlook and its current share market travails.
What’s interesting from my perspective is that these very same observers completely missed China’s astonishing share market run over the past year.
Now, whilst the market’s run was overblown and ripe for significant correction, surely a share market surge as significant as what China had experienced would have warranted more mainstream press coverage?
Sadly as we know, negative news always captures the public’s attention more than good news, so scribes have been busy penning stories of China’s demise.
We have come across some interesting thoughts from UBS that hopefully will provide more properly-informed debate.
Commentary with regards to China’s stock market volatility needs to tempered by taking into account a few very important facts – China’s Shanghai composite index had risen by 152% since July 2014 and 59.7% since the start of this year, while the Shenzhen SME board had risen by 138% since the start of this year.
In such a situation, a market correction of the type we’re now witnessing is inevitable (indeed, it’s almost a necessity).
Such retracements during bull market situations are a very healthy and necessary occurrence.
Aside from fundamental reasons such as monetary easing and market reforms, the China market rally has also been driven by new liquidity from retail investors and momentum, as well as a belief that supportive policies from the government.
This led to a situation where stocks were clearly becoming overvalued.
By mid-June, the average price-to-earnings (PE) ratio of Shanghai listed companies was 32, for Shenzhen’s SME Board the average was 85 and for the technology-heavy ChiNext the average was close to 150.
As a result, many investors are likely to have been willing sellers.
Their decision to sell has also coincided with measures taken by Chinese regulators to cool the market down.
Concerned by frothy market conditions and the rapid growth of market leverage, the China Securities Regulatory Commission (CSRC) began to tighten margin financing regulations during early 2015, warning investors of downside risks during April.
Under increasing regulatory pressure, over-the-counter (OTC) margin financing companies consequently asked clients to reduce or unwind margin positions, helping to trigger the market sell-off.
One of the key features that distinguish current market volatility from previous stock market boom-bust episodes is the widespread use of leverage.
Although the much more widespread use of leverage compared to past cycles means that spiralling deleveraging has aggravated the pace of this year’s sell-off, the financial system’s exposure remains relatively small.
According to some market estimates, securities companies now have RMB 1.8 trillion in outstanding margin positions – down from mid-June’s peak of 2.27 trillion – but still more than 80% higher than at the start of 2015.
More noteworthy, however, is the non-transparent and unregulated nature of OTC margin transactions, the rampant development of which may have significantly augmented overall market leverage.
Current market estimates of this stand at around RMB 1~1.5 trillion, including “umbrella trust products”, private financing companies, P2P lending, leveraged products from fund companies’ subsidiaries and securities companies’ asset management branches.
The sell-off, initially triggered by stretched valuations and tighter regulation, has been exacerbated by the unwinding of these significant margin positions.
This was further aggravated by the fact that the only “protection” for downside risk was to short the index.
As the share market decline has intensified, deleveraging pressures have risen, forcing more people to search for downside protection, turning these self-reinforcing forces into a vicious cycle.
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Measures to cool down China’s stock market
Despite different public opinion to the contrary, the Chinese government stepped in quite quickly in an effort to stabilize the market.
Various authorities under the State Council have adopted a host of measures over the past few weeks.
One of their primary aims is to stabilize both the capital market and the financial system.
In my view, the sharp correction in the stock market should have a limited impact on the stability of China’s overall financial system, which is dominated by the banking system.
Even though banks may have become involved in the equity market through various wealth management products and OTC channels, even the highest market estimate of potential bank exposure (up to RMB 2 trillion) is dwarfed by the RMB 180 trillion in banks’ total balance sheet.
One of the really interesting aspects of China’s current share market rally has been the participation of ordinary retail investors.
Household participation in the stock market rose sharply in recent months, with the latest official numbers suggesting there are about 175 million A-share accounts, with 29 million accounts classified as active.
The government may be concerned that large and widespread investment losses could lead to a notable negative wealth effect, which could weaken consumption.
However, considering that stock prices rose by more than 150% between July 2014 and mid-June 2015, the +30% decline over recent weeks should have a relatively modest impact on general household wealth.
Those hardest hit will (as in all bull markets) be those who joined the market late and with significant leverage.
I believe the current stock market turmoil will ultimately only have a limited impact on China’s real economy.
The primary justification for this is that despite the recent surge in stock market prices and participation, equities still account for only about 20% of overall household financial wealth, compared with 54% in deposits.
If we throw in property, the equity share goes down to 12-13%.
China household wealth – June 2015
The importance of equities in household wealth has shot up over the past three quarters by an estimated 6%.
The loss of this quick gain may not be as important for consumption as it could have been if the gains had been achieved over a longer period of time, as there is little evidence of earlier stock market gains featuring substantially in household consumption.
Moreover, only ambiguous empirical evidence can be found regarding the correlation between consumption and stock prices.
Interestingly, the correlation between Chinese consumption and equity prices is not historically strong, partly because investors have not typically depended upon equity investment returns as their primary source of income.
Instead, wage growth has provided the vast bulk of incomes.
Furthermore, equity has played only a relatively modest role in the financing of China’s real economy.
During 2014, equity financing made up only 2.6% of new total social financing, rising to a still-modest 4.2% during January-May this year, reflecting the lesser importance of equity-generated funding in China’s banking-dominated financial system.
Therefore, the equity market turmoil should not have a big impact on the financing of corporate spending and investment.
In 2014, equity financing made up only 2.6% in new total social financing, and this share rose sharply to 4.2% in January-May this year, reflecting the lesser importance of the equity market in a banking-dominated financial system.
Despite the sell-off, the Shanghai equity market is still up 20% YTD and 90% up from a year ago, whilst the Shenzhen equity market is up 44% YTD and 80% over a year ago.
More importantly, it can be argued that given how quickly these gains were made, not a significant portion has been cashed out for consumption.
As a result, most of the losses sustained during the recent sell-off related to previous gains that remained mostly on paper.
What about Gold?
China recently updated its ‘official’ gold holdings, which revealed that its gold reserves now stand at 1,658 tons – which is just 600 tons more than the country revealed it held back in 2009.
Given that China now mines more gold than any other country (it has mined more than 2,000 tons of gold since 2009) and much of that gold ends up in the People’s Bank of China, its difficult (indeed almost impossible) to believe that these figures are genuine.
Furthermore, depending on the month the country is also the No. 1 or No. 2 gold importer in the world.
It has imported well over 3,300 tons of gold through Hong Kong and has also imported nearly 700 tons from Switzerland since January 2012.
The reality is that China most likely maintains gold reserves well in excess of its current stated gold holdings.
Gavin Wendt is the founder of MineLife, publisher of the MineLife Weekly Resource Report
Telephone: 02 9713 1113
Mobile: 0413 048 602
Skype: glwendt
Twitter: glwendt
www.minelife.com.au
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