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Oxford Financial Group, LTD


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Investment e.Perspective

Current Issue | May 15, 2019

Understanding the Chinese Market Crash

By: Brendan O'Sullivan-Hale, MBA, CFA, Senior Investment Strategist & Oxford Investment Fellow

CNBC, the Wall Street Journal, Bloomberg and CNN all have referred to the 100-plus percent increase in the Chinese stock market from last July to this May as "meteoric," but perhaps even more reminiscent of a meteor is the Shanghai Stock Exchange's 30% fall over a mere 15 trading days. Smoldering in the crater at the worst point were more than 2,000 companies whose trading had been halted – some 97% of listed shares1. In a decision it is very likely to regret, the Chinese government stepped in to support the market, which has rallied, at least for now.

This is not the first time this has happened. The onshore Chinese market went through a similar boom and bust in 2006-2007, and proved not to have a meaningful impact on China's growth. This time is likely no different on that score. The excitement in Shanghai and Shenzhen is not, in and of itself, particularly important for the Chinese economy, let alone the global one. But it is meaningful in exposing the reality that the thesis that the Chinese economy is run by competent technocrats has its limits.

Five key factors are important in understanding the Chinese markets' run-up and fall.

  • A closed economy. For all its trade with the rest of the world, for most individuals in China the economy is quite closed. Capital controls are in place, meaning that few investors have the ability to buy assets outside China. Available investment options are bank deposits (until very recently offering negative real interest rates), real estate, gold and stocks. With China's infamously high savings rate, distortions in all of these markets (with the possible exception of gold, for which there exists a global price) are inevitable.
  • A closed IPO market. In Shanghai last fall, private equity investors complained to me that regulators' reluctance to allow new listings meant that lacking a free-wheeling IPO market, making money in private equity was getting much harder. Private equity investors now had to grow companies rather than just market them. While it was hard for me to work up much sympathy for their plight, an unintended consequence was that some companies that did have listings turned themselves into financing vehicles and started changing their stripes. From January to May more than 80 listed companies changed their names and business models, including a flooring manufacturer that got into online gaming, and a fireworks manufacturer that became a peer-to-peer lender2.
  • A relatively undeveloped onshore stock market. Unlike more advanced economies, the market capitalization of the Chinese stock market is equivalent to around one-third of GDP, compared to approximately 100% in the United States. So even though the absolute size of the Chinese market is large, its relative importance is limited. Trading in onshore stocks is mostly the province of retail investors, who are not known for sophisticated analysis.
  • High levels of margin debt. Prior to the crash, margin debt accounted for around 8.5% of free floating market cap, far above U.S. levels of approximately 2.5%3. And the U.S. level is already high relative to history – at levels seen prior to the 2000 and 2008 crashes. At triple the debt level, China's market was even more vulnerable.
  • A link between the bull market and government propaganda. In contrast to the relatively low profile taken by his predecessors, Chinese president Xi Jinping has been out front. Xi has been a popular subject for state-funded academic research, including "the 'essence of Xi Jinping's series of important speeches' and the 'innovation in Xi's key speeches.'"4 Rather than Mao's Little Red Book, there is a Little Red App named Xuexi Zhongguo, its name a pun that can alternately mean "study China" or "learn about Xi's China." Most significantly, in the popular press, mostly state-controlled, the incredible bull market in Chinese stocks was linked to Xi's leadership.5

Limited investment options, unsophisticated retail investors, high levels of debt and optimism about fireworks companies cum lenders and their ilk formed a heady brew that propelled the market to remarkable heights and made it vulnerable to a fall. While this has been fascinating to watch, for the Chinese economy this probably doesn't mean much. Only around 50 million people have stock accounts in China, around 5% of the population. The margin debt levels, while large relative to the stock market size, are small relative to the banking system. China's economy may indeed be slowing but its link to the stock market is mostly coincidence.

What is more concerning is how the Chinese government has reacted. Authorities have stepped in to directly and indirectly support the market, directing pensions and state-owned enterprises to invest in stocks. The Peoples Bank of China is providing financing to brokers to establish a fund to support share prices.

There is no legitimate policy reason to step in to arrest the pricking of a bubble in a relatively inconsequential corner of the economy. But Chinese authorities made the mistake of employing their propaganda machine to link the bull market to Xi's leadership. The government's recent backing of the market may be a short-term win – as of this writing stocks have recovered around 10% of their value – but in the long term it is bound to be a mistake. The government has now staked its economic credibility on defending indefensible prices. At this game, it is bound to lose.

To outsiders – economically this doesn't matter much. Few foreign investors have much invested in China's onshore markets. But in a significant way China's government has lost face among many foreign observers, including Oxford. MSCI has backed away from including A-shares in its flagship market indices6. The International Monetary Fund, which had indicated that the Chinese renminbi was nearing eligibility for inclusion in its Special Drawing Rights basket7, is surely reconsidering. China's government’s credibility, not its economy, is the greatest casualty of the recent rout.

1Hunter, Gregor Stuart and Ma, Wayne. "How China's Stock Market Thinned as it Plunged." Wall Street Journal. July 21, 2015.
2"China's Stock Market Bubble: A Goring Concern." The Economist. May 30, 2015.
3Verhage, Julie. "Macquarie: Chinese Margin Debt Has Much, Much More Room to Run." Bloomberg Business. June 24, 2015.
4Phillips, Tom. "Xi Jinping: the Growing Cult of China's 'Big Daddy Xi.'" The Telegraph. December 8, 2014.
5"China's Stock Market Crash: A Red Flag." The Economist. July 7, 2015.
6Moore, Elaine and Noble, Josh. "China's MSCI Hopes Soured by Stock Rout." The Financial Times. July 17, 2015.
7Mitchell, Tom. "Stock Market Rescue Places China's Renminbi Reform Under Threat." The Financial Times. July 12, 2015.

The above articles represent the opinions of the authors as of 7.30.15 and are subject to change at any time due to market or economic conditions or other factors.