The roller-coaster ride of the Chinese stock markets in the past 13 months reveals the snowballing effect of the actions of disparate players. The Shanghai Composite Index soared 150% over the past year before shedding 30% in a little more than three trading weeks. But neither the wild ride up nor down seems related to the underlying performance of the listed companies. As China attempts to regain its poise after last week’s rout, Wharton experts note that several obstacles stand in the way of greater stability in the market.
When the market was on its way up, the state led the caravan with its desire to command very high valuations for Chinese stocks. Higher stock prices would also help China’s state-owned enterprises (SOEs) cut their debt levels because they can sell shares they own to pay back borrowings. The government’s propaganda machinery propped up the stock markets, while at the same time, officials relaxed rules to make it easier for investors to borrow money to buy stocks — spurring demand from both unsophisticated small investors and opportunistic wealthy ones. The government’s successful economic track record gave its pitch the required credibility, and institutional investors eventually joined the party.
In a country where gambling, though illegal, is part of the culture and persists in clandestine settings, the stock market merely presented an alternative.
A desire for image control seemed to drive the Chinese government’s stock valuation logic. Consider this: On April 20, Bank of China’s share price was 4.74 renminbi, with a P/E of 7.8. A report by state news agency Xinhua in the Communist Party newspaper People’s Daily noted that “the current price-earnings ratio of Bank of China is … undervalued.”
Students are being enlisted in the effort to revive the markets. Beijing-based Tsinghua University’s School of Economics last week instructed students at a graduation ceremony to “shout loudly the slogan, ‘revive A shares, benefit the people,’” according to a report by James Kynge of The Financial Times. “A-shares” refer to shares bought and traded on Chinese exchanges such as the ones in Shanghai and Shenzhen, and mostly held mainly by local investors and qualified foreign institutional investors. Other foreigners are allowed to buy only “B-shares.”
Tsinghua is known as “China’s MIT,” and it is reputed for its influence on government policies; its founding dean was former premier Zhu Rongji. Interestingly, Tsinghua later changed that slogan to “Actions speak louder than words, shoulder responsibility, be innovative, benefit the people,” according to a report in the South China Morning Post. Tsinghua described the earlier slogan as a joke suggested by students and not approved by its faculty.
The World’s Biggest Debt-to-equity Swap?
Wharton emeritus management professor Marshall Meyer, a long-time China expert, says that “the theory that the market was pumped up to help SOEs to reduce their debt is plausible.” According to a report by the Peterson Institute for International Economics in Washington, D.C., China’s SOEs were saddled with a debt-to-equity ratio of nearly 200% by 2013, and “face the greatest risk of insolvency” among all Chinese firms.
“Someone has called this the world’s biggest debt-to-equity swap,” says Meyer. “The government hoped that it could manage the market upward and use the market mechanism to relieve some of the debt of SOEs and everybody will be happy. But it went out of control.” Government officials wanted to ease the market upward and achieve a win-win outcome where corporations were relieved of debt and individual investors felt wealthier, he adds. “The government thought this would be a clever way out of the debt problem, which remains huge.”
The main tool of the government to boost stock prices was to relax rules on margin trading, or buying stocks with borrowed money, where the purchased stocks secure the loan. Chinese authorities officially allowed margin trading starting in 2010, but have since regularized it and lowered thresholds on collateral requirements. Total margin trading has increased from 403 billion RMB ($65 billion) to 2.2 trillion RMB ($355 billion) over the past five years, according to various media reports. As of July 9, that figure had shrunk by 37%, The Wall Street Journal reported.
“When the government says jump, people jump.” –Marshall Meyer
“Once margin buying was possible and the government unleashed the propaganda mill, some people were earlier than others to jump in,” says Meyer. “The shrewd people — mostly individual investors — borrowed a boatload of money to buy stocks. They borrowed the money, drove the prices up and got out real quick, leaving ordinary, semi middle-class [people] in Beijing or Shanghai out of … a lot of money.” In other words, crowd sentiment ruled. “People looked over their shoulders to see what other people were doing and made their bets accordingly,” Meyer notes.
As for bubbles, it was “Tulipomania all over again” in the Chinese stock markets, says Meyer, referring to the 1600s Dutch speculative bubble of investors chasing up prices of tulip bulbs before they crashed. In China, the government’s conviction that stock values should be higher was the chief driver. “Against all reason, everyone was pumping stocks in China because the government advised them to buy stocks,” he adds.
Meyer traces that phenomenon to the “obsession with GDP in China.” It didn’t matter that China’s gross domestic product growth rate has been declining in recent years — from 10.5% in 2010, it fell to 7.7% in 2013 and 7.4% the following year. “The whole problem is that GDP is ‘made in China’; it’s a product,” Meyer says. “We tend to think of GDP as an outcome of the functioning of the real economy. But in China, GDP targets are drivers of the real economy. So it becomes a circular argument.”
Indeed, China has a weaker link between GDP growth rates and stock market returns compared to that in other countries, according to a 2015 research paper that Wharton finance professor Franklin Allen co-authored with three experts from the Shanghai Advanced Institute of Finance. “Stock market returns in both developed economies, such as the U.S., U.K., Japan, Korea and Taiwan, and large emerging economies, such as South Africa and Russia, are strong predictors of GDP growth,” the paper says. “The correlation between market returns and future GDP growth for China, however, is much lower and statistically insignificant.”
While China’s government wants stock valuations to grow at the same rate as its GDP, “that is disconnected from the underlying performance or the fundamentals of the [listed] firms,” Meyer notes.
Wharton management professor Minyuan Zhao explains why Chinese investors tend to ignore fundamentals. “Precise firm-level information is hard to come by, so many not-so-savvy individual investors are trading on sentiments, stories and their understanding of government policies,” she says. “Unfortunately, with such investors in the majority, the market is characterized by high synchronicity across stocks … and high volatility as a whole.”
“This episode should educate investors about how the Chinese economy works and boost the market’s confidence in the Chinese government’s ability to generate designer financial outcomes,” adds Wharton marketing professor Z. John Zhang.
When Allen looked at the fundamentals of Chinese companies, he found serious problems. “With much higher levels of investment compared to listed firms from the U.S., Japan, India and Brazil, Chinese firms generate lower net cash flows, implying low investment efficiency,” according the research paper he co-authored. The paper, titled, “Explaining the Disconnection between China’s Economic Growth and Stock Market Performance,” studied the performance of Chinese stock markets between 2000 and 2013.
“Lower cash flows are associated with more related-party transactions for Chinese firms, indicating deficiencies in corporate governance,” the authors write. They point to other research that documents how controlling shareholders of listed firms divert assets by providing loan guarantees to subsidiaries or related parties, or by paying for the debt and expenses.
“Problematic IPO and delisting processes exacerbate the adverse selection of firms into the market,” the paper continues. The researchers cite three well-known Chinese companies — Baidu, Alibaba and Tencent — which have avoided the Chinese stock markets and secured listings on other exchanges such as New York and Hong Kong. They also note hurdles imposed by stock market regulators, such as requiring IPO aspirants to show profits in the previous three years and enforcing IPO quotas for various regions of the country.
“There is a weird compact between the government and the people…. ‘You take care of us, we’ll take care of you’ — that was the deal.”— Marshall Meyer
With the stock market crash, investors now face more troubles. They have to cough up more cash or other assets to meet their margin calls, since their borrowings are secured by the value of the stocks they bought, and the market crash has diluted that collateral.
The government has, meanwhile, launched a spirited effort to shore up the stock indices again. Soon after the crash last week, trading on nearly half of the 2,873 stocks listed on the Shanghai and Shenzhen exchanges was suspended, but that proportion has since dropped to 31%.
It has also taken steps to rein in margin trading, banned short selling, and authorities have threatened to prosecute violators and those spreading false rumors about the market. Last weekend, 21 of China’s top brokerage firms agreed to invest 120 billion yuan ($19 billion) in the stock market, while pension funds also chimed in. Major shareholders of listed companies are banned from selling shares for six months. New IPOs, which could encourage investors to sell existing stocks to buy new ones, have been prohibited to stabilize the market. Meanwhile, the government has cut interest rates to lower the cost of capital in a bid to boost economic growth.
Chinese investors will comply with those conditions out of fear, says Meyer. “Since the anti-corruption campaign in China [which began in November 2012], the level of fear has just taken off,” he adds. “The laws are so vague that many can be accused of operating outside of the rules.”
Meyer recalls a precedent for those interventions in China’s real estate markets. When housing prices started to tumble a couple of years ago, the government stopped sales using various devices. “They throw in bureaucratic impediments, increase transfer taxes, raise down payments or do whatever is necessary to prevent lower prices from being recorded,” he says.
Will the Intervention Work?
Allen, who is also a professor at Imperial College in London and head of its Brevan Howard Centre, frowns at the government’s tactics to lift stock valuations. “Adopting such interventions is a very bad idea,” he says. “It will cost them a lot of money and, in the end, it won’t work.”
If the Chinese government wanted the listed stocks to find their true levels, it failed because the administration was trapped by its own propaganda, Meyer says. “Once they started their propaganda going — ‘buy shares, buy shares, buy shares’ — they couldn’t stop it, because that would be an admission that the policy is wrong,” he adds. “They were hoist with their own petard. And everybody had to just hope that the market wouldn’t crash too quickly.”
The latest market-boosting efforts have also had some unintended consequences, according to Zhao. “The strong medicines prescribed [recently] failed because they were not able to stem the fear among the retail investors. Instead, the state support of the market provided the opportunity for the retail investor to leave en masse,” she says. However, the “panic is going away,” thanks to the administrative tools that followed, such as prohibiting short-selling, increasing margin limits and ordering state entities to increase holdings, she adds. China is deep-pocketed enough to finance a market recovery. It had the world’s largest foreign exchange reserves of $3.9 trillion as of last December.
But Zhang says the state interventions raise troubling questions. “The Chinese government surely has the power and resources to prop up any market, and there should not be any doubt about that,” he notes. “The only questions are: at what cost, to whose benefit and with what long term consequences?”
“Adopting such interventions is a very bad idea. It will cost them a lot of money and, in the end, it won’t work.” –Franklin Allen
Short Memories or Painful Lessons?
How will retail investors respond to the market crash? “It depends where we end up, but yes, a lot of people will be worried and may withdraw from the market,” says Allen. Adds Meyer, “Memories are short and who knows what the next wave of Tulipomania is going to be.”
Zhao cites leverage as “the main culprit in the sharp rise — and then the crash — of the market.” She suggests that upper middle income or relatively wealthy investors were the most hurt by the crash. “It will make the regulators think twice about leverage, but it will not have long-term impact on the retail investors,” she says. “After all, these were the investors who participated in the bull market in 2007, only to see the SSE Composite Index dropping from 6124 to 1665 the next year.”
Retail investors will return with gusto, Zhang predicts. “This is not the first time in China when people in back streets with no financial knowledge bragged about their skills in stock picking,” he says. “The market is simply too popular to fall” and stay down in the long run.
Few doubt that institutional investors will return to the Chinese stock markets. However, going forward, “they would include the risk factors in their calculations,” says Zhao. She notes that the Chinese government is determined to develop its stock market, putting that effort at the center stage of its economic transition strategy. “The global investors are betting on the track record the Chinese government has had: If the government wants to do something, it will make it happen at all costs. Of course, this kind of game is not for everyone.”
Zhang adds a note of caution. “The long-term prospects of Chinese markets are still strong, but in the short run, they are more for gamblers than for investors, and more for experts than for amateurs, as non-market forces can play a decisive role.”
Time for Reforms?
The crash provides China with an opportunity to introduce structural reforms to bring greater transparency and let the market set stock prices.
Allen notes that the latest volatility “seems to be a liquidity fueled bubble made possible by extensive margin loans.” His recommendation: “They need to reform the market with regard to the margin rules to make it more difficult to borrow and invest.”
In the paper Allen co-authored, the authors call for the market regulator to lower the financial hurdle for IPOs, and encourage more privately owned firms, especially those from growth industries, to enter the market. Improved corporate governance is another goal they propose.
Meyer agrees that the time is opportune for reforms, but suggests that the opposite is happening. “Investors want protection from losses, the government wants to keep control while dispersing ownership,” he says, referring to China’s “mixed ownership” model of private investors and the state jointly owning companies. “Neither is conducive to transparency or the removal of props.”
“The market will move towards greater control and regulation, but not necessarily more transparency.” –Minyuan Zhao
Zhao points out that while the crash highlighted the risks of a speculative market, “the crisis was [staved] — at least for now — with brutal forces thanks to the vast state-owned or state-controlled resources that the government was able to mobilize in a short period of time.” Against that backdrop, she predicts “the market will move toward more control and regulation, but not necessarily more transparency.”
At the same time, Meyer is encouraged by a recent government diktat to SOEs to buy back their shares and grant stock options to their executives. “Both the firms buying shares and granting stock options puts more power in the hands of managers,” he says.
Yet, Meyer is not sure if those buybacks and options will yield the desired results. “If the theory of incentive alignments is meaningful, firms might as a consequence run on a more rational basis,” he says. “Yet, I don’t know if that is possible, because so much of what they are doing otherwise looks like they are going back to a controlled economy.”
Obstacles to Reforms
Meyer points to the biggest obstacle to any reforms in China’s stock markets. “The government is controlling both sides — trying to control and intervene in the markets on the one hand and trying to control and intervene in the firms on the other,” he says. “I don’t know whether that is sustainable in the long run. How can the markets discipline the firms if both are under the influence of the government?”
The relationship between the Chinese government and retail investors is another factor that could thwart reforms, according to Meyer. “There is a weird compact between the government and the people,” he says. “The government wanted widespread investment in the stock market so as to get some market discipline in the operation of firms while retaining ultimate government control. People wanted safe investment — [the stock markets] would go up and not go down, and they wanted to ratchet it up. ‘You take care of us, we’ll take care of you’ — that was the deal.”
If the government fails to provide its people “a modicum of economic security, the political risks go up enormously,” says Meyer. “So the issue is going to be: government non-interference in markets and the risks of interference versus the political risks if the government doesn’t continue to intervene. I don’t know how that is going to play out.”
In the meantime, investors have no option but to wait out a recovery, if one is on the near horizon. “Despite the best efforts of the Zhongnanhai [the seat of the Chinese government] [and] stylists to keep everyone’s hair looking nice and dark, there are going to be a lot of gray hairs,” Meyer predicts.