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Curious Case of Chinese Equity Market “Premier Deng Xiaoping “It doesn’t matter if a cat is black or white, so long as it catches mice”
Nishant Malhotra
Double MBA: MBA: China Europe International Business School (CEIBS), Shanghai, China 2011 exchange: Nanyang Business
School, Singapore and MBA: Symbiosis Institute of Business Management, Pune, India 2002
Acknowledgement & Summary
The purpose of this report is to give an unbiased view on Chinese equity markets and chronicle the events which
led to the recent much typed turmoil. This paper makes an attempt to understand what happened over the past
few years in Chinese equity markets and is based on fundamental and behavioural analysis. The report is
predominantly based on secondary research and relies on reports and articles published on China financial
markets. Some of the prominent reports covered in this research are Real value of China’s Equity Stock Market by
Jennifer Carpenter, Fangzhou Lu and Robert Whitelaw and China Financial Stability report 2014.
The inspiration for this report is based on my experience in China when I pursued my second MBA from China
Europe International Business School (CEIBS); Shanghai a globally top business school and my fascination with
Chinese history and culture. The research report is backed by data with sources listed and is second in my series of
papers on China. The first one which I recently published on LinkedIn is a very generalist report titled China:
Ragging Han Bull.
I personally want to thank my Prof Xu Bin who is an inspiration for me and taught Macroeconomics in CEIBS,
Finance Prof Fank Yu who always motivated students to read nonfiction books on finance, Prof Shimin and MBA
office particularly Ning Ma and Daniel. The report is dedicated to some of my classmates in CEIBS as well as people
with whom i met in China. I will always be in touch with all of you and consider you an asset to China and humanity.
“My name is Benjamin Button, and I was born under unusual circumstances. While everyone else was aging, I was gettin' younger... all
alone” Brad Pitt from the movie Curious Case of Benjamin Button
China one of the oldest civilizations still exudes charm and youthful vigour seen missing among some younger
civilizations.
China: The Middle Kingdom China is the world’s second largest economy with GDP of $9.24tr. China became the world’s largest investor in
2010.1In 2014, China made USD4.9tr of total fixed investment, compared to $ 3.4tr in US and $1.1tr in Japan. China
has also been the biggest contributor to global growth contributing $0.9tr to increase in global GDP, with $0.6tr
from US and $0.3tr from UK. 2China is the world’s largest importer of energy and recently overtook US as the
largest importer of crude oil. China has the highest forex reserves in the world which amount to $4.2tr and has the
largest holding of US treasuries in the world.
China has over the past few years implement pro economic reforms including increasing the quota and loosening
regulatory requirements for foreign investors to invest in A share market through QFII route, launching ETF and
stock index futures, opening Hong Kong Shanghai stock connect to allow foreign individual investors to invest in A
share market and investors from Mainland China to invest in H share market. The asset size of Chinese banking
system is $23tr about three times the asset size of shadow banking in China. China is looking at allowing private
capital to set up banks to make banking sector more competitive and slowly & consistently pursuing economic
reforms.
1 Real value of China’s Equity Stock Market by Jennifer Carpenter, Fangzhou Lu and Robert Whitelaw
2 http://www.businessinsider.com/r-china-becomes-worlds-top-crude-buyer-despite-economy-stuttering-2015-5?IR=T
Overview of Chinese Stock Market
China opened its stock market in 1991 in Shanghai and Shenzhen and is the second highest equity exchange in the
world with a market cap of $9tr before the recent equity downturn. China stock market is still young driven by
retail/ individual investors who account for 80% of trading volume although retail penetration is around 13%.
Institutional investors hold about 70% of tradable A share stocks while retail investors hold roughly 22% of tradable
A share stocks with QFII holdings of less than 2%.
Second China’s stock market is not advanced like developed countries which rely on high speed trading in stocks,
dark pool account and still order driven as compared to order or quote drive market in developed countries. On
the hindsight this might be good since high speed trading might make the price discovery better but preference is
always for humans to make fundamental or technical research for investing rather than rely on machines. (Matrix
movie remember...machines taking over the world) ... refer to Michael Lewis new book Flashpoint..Black box
China broadly equity shares trade in Shanghai stock exchange, Shenzhen stock exchange and Hong Kong stock
exchange. The breakup of the two exchanges is given below. CSI 300 consists of the largest 300 stocks by market
capitalization in share A class of stocks listed in Shanghai and Shenzhen stock exchange. The share A class is the
largest class of shares in China and consists of the most liquid stocks. Apart from retail investors from China, even
foreign intuitions can invest in these stocks through QFII (Qualified Foreign Institutional Investors) route which
was launched in 2002. In 2013 China had raised the limit of quota in QFII to USD 80bn from USD 30bn. Going
forward we shall be discussing CSI 300 since it is the right barometer of equity market sentiment in China.
ChiNext exchange launched in 2009 caters to small and medium companies and is very similar to NASDAQ in US.
There are 464 companies listed in ChiNext which are mainly in hi tech industry. The PE ratios in Chi Next can be
very high and serves as an alternate source for small companies for raising capital.
The other index where stocks from Main land China are listed is in Hong Kong (Hang Seng index ticker HSI). They
are listed in HKD. The report is going to ignore B share market. To understand correctly Mainland Chinese
companies are list in A share market in Mainland China in RMB and same companies are listed in H share market in
Hong Kong in HKD.
Shanghai Description Shenzhen Description
A Share
The shares traded here are of companies incorporated in China and
listed on Shanghai and Shenzhen stock exchange. It is only open to
retail investors and foreign institutional investors through QFII route
and is the largets class of shares in China
Small and Medium
entreprise board
B Share
Open to foreigners and also retail investors; companies are listed in
USD in Shanghai and SGD in Shenzhen ChiNext
For small companies especially in
technology and pharmaceutical
Background of Reforms and their implications in equity markets
QFII
One of the major initiatives taken by China in recent years is to allow QFII to invest in A share market. The quota of
QFII was USD 80bn before recent equity market turmoil and has been increased to USD150bn. QFII comprises of
more than 200 asset managers, pension funds, insurance fund houses etc. Although QFII account for less than 2%
of share holding in A share market, they help in better stock coverage analysis back by years of core competency in
fundamental research and risk systems and are opinion makers for Chinese investors for investing in stock market.
ETF
Introduction of ETF provided investors to take exposure to Shanghai index in a low cost way and thus fuelled
increase in retail/individual participation.
Shanghai- Hong Kong Stock Connect
3According to Hong Kong Exchanges and Clearing Limited “Shanghai-Hong Kong Stock Connect is a securities trading and clearing links programme to be developed by Hong Kong Exchanges and Clearing Limited (HKEx), Shanghai Stock Exchange (SSE) and China Securities Depository and Clearing Corporation Limited (ChinaClear), aiming to achieve a breakthrough in mutual market access between the Mainland and Hong Kong”. The program is to allow foreign investors including investors from Hong Kong to invest in A share market. Investment in ETF, B share, bonds, REITS, Structured Products and other securities will not be included. Mainland institutional investors and those individual investors who satisfy the eligibility criteria (i.e. Individual investors who hold an aggregate balance of not less than RMB 500,000 in their securities and cash accounts) will be accepted to trade SEHK Securities through Shanghai-Hong Kong Stock Connect. The program is bounded by quota as outlined below. The Northbound Aggregate Quota is set at *RMB 300 billion. The Southbound Aggregate Quota is set at RMB 250 billion. The Northbound Daily Quota is set at RMB 13 billion, and the Southbound Daily Quota is set at RMB 10.5 billion. This move is a good step forward since it would allow retail/individual investors both from Mainland China to invest in companies listed in Hong Kong which includes many global companies and foreign individual investors to invest in A share market.
Other development over the past few years has been opening up QDII (for investments abroad from China) which
allows institutions to invest aboard in equities, fixed income and derivatives, introducing stock index futures etc.
*RMB is also known as Yuan and at some places i have quoted Yuan
3 http://www.hkex.com.hk/eng/market/sec_tradinfra/chinaconnect/Documents/Investor_FAQ_En.pdf
Shadow Banking
After credit crises, stricter regulations has helped to regulated banks however shadow banking has emerged as
the one of the fastest growing sectors with asset size of USD75tr. The shadow banking size is still dominated by
United States and Euro area but emerging economies like China, India and Argentina are fast emerging as major
growth countries for shadow banking.
Source: Financial Stability Board
What’s shadow banking?
FSB describes Shadow Banking “As credit intermediaries involving entities and activities outside of the regular
banking system. Also known as market based financing helps in facilitating credit in the real economy by reaching
out to especially small business in a much faster and cheaper manner when compared to banks”. Although shadow
banks work like banks they are not regulated like banks and thus can become systemic risks due to their linkages
with banks. Shadow banking are an important part of economy and if properly regulated can help in allocating
capital in more efficient and cheaper manner.
Emergence of shadow banking in emerging economies has been very rapid especially in economies like China and
India where it is not easy for small and medium enterprises to get funding. Although China has opened ChiNext to
help small and medium enterprises to gain access to capital from the market, there is gap which has been used by
shadow banking to grow. FSB estimated that shadow banking in China is around USD 6tr in 2013 and could be
around 8tr by 2015. Shadow banking in China is simple and not financially as developed like United States and
instruments in showdown banking in China includes securitised assets and derivatives. Shadow banking evolved
during the 2007 crises in China as a better and faster way of providing capital to companies, infrastructure projects
and real estate sector. Shadow banking was instrumental in helping China avoid recession during 2007 due to its
ability to supply credit in the economy at cheaper and faster pace.
Chinese banks are state controlled and therefore need more capital and being tightly regulated loans are
influenced also by Guanxi (mandarin it means social relations for facilitating businesses). It is estimated that about
50% of the shadow banking are indirectly funded by banks so they can participate in better return through its tie up
with shadow banks. Due to this shadow banking in China are very interrelated although China does not have huge
market of CDS (Credit Default Swap) compared to United States which resulted in a systemic risk and global
meltdown (LEHMAN BROTHERS collapse triggered a spiral of collapse among financial institutions through
interlinked CDS on it and the whole banking sector came down like a pack of cards. Thanks to financial innovation
since CDS is supposed to diversify risk and like derivatives can also work as weapons of mass destruction). Although
the shadow banking is huge, it is still a distinct second in terms of capital allocation in China to banking sector. In
terms of size shadow banking is still small compared to asset size of banking sector in China
Source: China financial stability report; LCD: Large 5 commercial banks in China
Chinese banks have assets of around 150bn Yuan ( about USD23tr) while its 5 big commercial banks asset share has
decreased over the years and is around 43% which is credible since they pose less of a systemic risk than about 5
years back.
Is Shadow banking a systemic risk in China?
Asset size of Chinese banks is $23tr while the size of China’s shadow banking is estimated to be around $6tr in
2013. Considering that shadow banking grew by 14% in 2014, the size in 2014 $6.84tr which is about 30% the size
of assets in Chinese banks. On conservative estimates about half of this is funded by banks in China and therefore
have an implicit guarantee which makes $3.4tr in unregulated market. This amounts to only 12% of the asset base
of banks in China and hence is of no serious implication. Another way of looking at shadow banking would be to
consider that $3.52tr is the outstanding wealth management products and even if 30% default, it amounts only
$1tr which is less than $5% of assets in Chinese banks and
Moreover shadow banking is slowing down due to strict regulations enacted by the Chinese government and key
steps taken by government in Rigid Redemption which we will see later “to let some wealth management products
default”. The growth in wealth management products has come down drastically with the incremental money
flowing into equity markets. b According to an article in WSJ, the outstanding value of shadow-banking products
stood at 21.87 trillion Yuan($3.52 trillion) at the end of November, up 14.2% from the level a year earlier, according
to estimates by Nomura Securities based on central-bank data. That growth is significantly slower than the 35.5%
rise it registered for the whole of last year and the 33.1% gain in 2012.
b: http://www.wsj.com/articles/chinas-shadow-banking-growth-slows-1419370402;
Source: WSJ
On a very aggressive basis even if 30% of the wealth management products default out of $3.52tr of wealth
management products which would make about $1tr. This is less than 5% of the asset size of banks in China and
thus does not pose any problems since China has low debt to GDP and can easily absorb any losses.
Shadow banking is not a risk in China since China has been very proactive in tightening its grip on this sector and
going forward will play a lesser role in the economy
Role of Shadow Banking in Chinese Equity Markets
Increase in risk free return: Shadow banking played a big role in development of wealth management funds since
Chinese investors are limited by rates on fixed deposit which is capped around 3%. 1Wealth management products
which were sold by showdown banks helped investors earn 5-7% return. Since these wealth management products
were backed by banks and hence indirectly guaranteed by China, it skewed investor’s behaviour due to higher risk
adjusted return basis i.e. to simply say generate a higher return for the amount of risk taken. More risk should
generate higher return and hence higher risk. An implicit guarantee caused wealth management products to work
like fixed deposits but generating higher return with no risk. This resulted in the risk free rate to be revised upward
from 3% to 5%-7% in Mainland China. CAPM (Capital asset Pricing Model) which is used to derive the required rate
of return of portfolio taking into account diversifiable risk and non diversifiable risk is used as a method of
computing future cash flows of stocks.
There are primarily two exchanges in China for same large cap stocks of companies from Mainland China, the Hang
Seng stock market for H Share stocks in HKD and Shanghai A share stock market in Mainland China. From 2011-
2013, the Shanghai stock market traded at a discount to Hang Seng stock market due to the revised upward risk
free rate in main land china. 1Since the same share is discounted at different rates (international investors
discounting the Hang Seng shares while mainland investor discounting A shares) there was no change in Hang Seng
shares and thus they traded at a premium to A share market in Shanghai.
One of the reasons the underperformance of Shanghai stock market during the same period was because of the
revised GDP estimates given by Chinese government to target 7% GDP growth from 10% which it had achieved
during the previous 15-20 years. This was due to the structural change which China adopted by moving from an
investment driven economy to consumption driven backed by services sector. This built a negative perception
among the investors. Moreover it is next to impossible to grow at 10% when you are a $9.4tr economy and the
world was in a severe downturn....Shows the misplaced expectation among many economists......
1 Real value of China’s Equity Stock Market by Jennifer Carpenter, Fangzhou Lu and Robert Whitelaw
This was a very good and decisive move by the Chinese government to structurally change the economy since
until then Chinese economy was driven by investment which had led to excessive supply in the system. This had
resulted in the supply curve to be shifted above while the demand curve remained at roughly the same levels. This
had resulted in decrease in price levels which would have altered the equilibrium of demand and supply and
caused deflation in years to come. (This was aptly propounded by my esteemed CEIBS Prof Xu Bin who is PhD from
Columbia Business School`). This was one of the fundamental reasons why Japanese economy collapsed and has
remained in deflation for two decades.
Behavioural Economics
Economics assumes that investors are rational and make rational decisions while investing in tune with Markowitz
theory of portfolio management but credit crises in 2008 has proved that this is really not true. Man is not rational
when investing and this is the basis of investing which is what behavioural economics follows. This is true since it
has been seen time and again especially the irrational exuberance shown by investors around the world ranging
from 1987 stock market crash in United States, Technology crash in 2001, LTCM crises, Credit Crises and will
continue till eternity. It is not limited to investors in developed economies but globally and China is not an
exception. We will come to it in a moment.
Finally the Chinese stock market to be an underperformer during this period was also the rapid proliferation of
wealth management products which generated a higher return on risk adjusted basis (higher return for lower risk).
This of course caused investors to divert money from the stock market to products in wealth management
products since they had a guaranteed return (implicit) attached to it. This is one of the most important reasons has
been in behavioural economics in China which is one of the key and fundamental reasons for panic among
investors recently when equity markets fell down. @The issue has been addressed by China in Financial Stability
Report in the topic titled “orderly breaking the practice of rigid redemption of wealth management products:” As
discussed before products in wealth management amount $3.5tr and most of the products are invested in short
term duration with higher return amounting to 5-7% to beat the interest rates in fixed deposit. Some of these
products are mix of structured products and the return is not guaranteed and could depend on the performance of
index. There are times when these products will not give the promised return (in the form of interest rates or
principal at maturity) and hence should default. However the issuer generally banks, insurance companies and
other asset managers give an implicit guarantee and step in to pay even during default.
@ China financial stability report
Real GDP
PD
Y1Y2
P1
P2
Aggregate Demand
AS1
AS2
This problem has proliferated in China and is known as “Rigid Redemption”. The government is addressing this
problem by allowing some of the products to default in an orderly manner. This is a brilliant decision since a
sudden change to allow default of all products would cause panic and social unrest. It is not easy to change the
mindset of people overnight but needs to done in a phased, orderly and consistent manner. China has already
reengineered a process by separating wealth management department from retail department which has helped in
better KYC ( know your clients) norms to be implement and investors being better aware of risks associated with
wealth management products. These has resulted in investors moving away from wealth management products
and moving into equities since the rally started in A share market in 2014. Moreover there have been a series of
defaults especially in trust products.
b “There was a high-profile default of a wealth-management product sold through Huaxia Bank Co. in 2012, and Citic
Trust Co., one of China’s largest shadow lenders, entered the spotlight in December that year after failing to pay
interest and principal to investors on a trust product it sold.”
Leading portents of Behavioural Economics include economists like Dan Ariely and Richard Thaler. Richard Thaler is
a professor in Chicago Business School and his new book is a highly recommended read by CEIBS Prof Frank Yu
(PhD Chicago Booth Business School), a young and brilliant economist. Dan Airely in his book Predictably
Irrational highlights how people misinterpret common behaviour based on existing biases.
His experience as a patient in hospital led him to first think how psychology works in real world. He experienced in
hospital that when nurses quickly peeled off his bandage it hurt more rather than when the bandage was peeled
off in a slow and consistent manner. This came as a surprise to nurses since they thought otherwise since a quick
peel off would hurt more but for a small time. This example serves as an analogy that the idea of phased defaults
in wealth management is a better way of making investors in Mainland China realise that higher returns come
with higher risks for which they should not be compensated…than a sudden change which will only lead to
misconception and unrest.
Recommendation
“The most would be to make it mandatory for all banks, asset managers and trusts who issue wealth
management and give advice on investments to recruit investment managers who have proper requisite
economics education and give mandatory training to its employees on basics of investing and portfolio
management ( Markowitz portfolio theory etc.) Second, there should be a very strong KYC (Know your client)
especially for trusts before they recommend anything to investors so they are able to communicate adequate risk
return dynamics to investors”
Curious case of Chinese Stock Market: Chinese equity Markets 2014-Present
CSI index 300 which comprises of A share stocks listed in Shanghais and Shenzhen which was one of the most
undervalued index in world gave a return of 150% in one year while Chi Next gave returns of 184% with PE
multiples trading at 84. However the markets started falling from 13 June and caused worldwide panic…. Let’s
understand the dynamics of A share stocks…..
Comparison of proportion of tradable shares held by institutions and individual in Tradable A share market
Source: The CSRC
Institutions hold about 70% of tradable A share stock, while retail investors hold roughly 22%, QFII less than 2%
and rest by domestic security funds like sovereign wealth funds. Although retail investors who have participation
rate of about 13% and roughly own only 22% of stocks (little better than India which is between 8-10%) account
for 78% of daily trade volume. This shows an inherent weak structure in asset management industry and
structural flaws in China’s equity market.
80% of the volume trades are done by retail investors which is the reason A share market has the highest volatility
among its peers at 18%1. Retail investors in China invest through banks or trusts on debt which is margin loans.
These margin loans results in leverage which works fine when the markets are going up but it tumbles when the
direction of market changes. The reason is margin calls i.e. like in futures market retail investors have to increase
their share of investment. Just to illustrate an example
A invests 100 RMB in stock ABC. Investor A puts 50RMB of its own and borrows 50 RMB from bank for which A pays
an interest. The example ignores maintenance margin to explain in simple terms while the minimum margin
(amount) is 50 RMB. The example illustrates the return investor can make. If the stock moves to 120 the return for
the investor is 20/50= 40% return while when the stock goes down to 80, the investor makes a loss of 40%. In a bull
market a 20% return on stock can be achieved in a few trading days. In this case the leverage is 2 times so the gain
or loss doubles. When the stock price goes down and the investor is not able to fund the account, the bank will sell
the holdings of the investor to recuperate its loss. (Bank starts losing if the stock price goes less than 50 and will sell
before this scenario. In this case even if the stock is good and with a potential upside in future would be sold. This
causes the market to go down since you tend to sell good stocks along with bad ones. This works like a spiralling
effect and causes panic and results in investors quitting who would otherwise would have stayed invested.
Stock ABC Investor A Bank
100 50 50
120 70 50
80 30 ( margin call to add 20) 50
In 2008 the prime reason for the markets to fall was the use of leverages which were as high as 30 to 50 times the
investment. In credit crises the leverages used were with institutions while in China retail investors used leverages
for investing. Retail investors tend to more panic prone since they do not have deep pockets and technical
knowhow compared to institutional investors. Also another difference in credit crises was use of short term
borrowing and roll over to finance long term borrowing and therefore it caused a duration mismatch and caused
panic selling when short term credit was not available. a. The speculative behaviour in China is one of the highest in
the world with turnover rate at 900% and 6% of the retail investors with college degree. (Prof Oliver Rui from CEIBS
has published a very interesting highlighting the same but it is about ChiNext which would be a bit different CSI
index).
Outlook: Equities A Share Market
China remains a long term bull with GDP growth rate of 7.1% this year and 6.9% in 2017 according to World
Bank.
A fall of 40% in stock market which was at best a correction is certainly not a crisis by any standards. As The
Economist mentioned the available tradable stock also known as free float is only 30% of GDP compared to
developed economies which has free float around 100% of GDP. The margin loan amount to less than 5% of assets
of Chinese banks is hardly a systemic risk which could include 20% of margin loans by shadow banking. Although
there are linkages between banks and shadow banks, as previous discussed CDS are not so wide and relevant that
they would cause havoc like they did in United States. With less than 15% of retail penetration with estimated
retails investors between 90mn to 100mn, the wealth effect will hardly result in increase in consumption and a
change in GDP. Moreover it seems that some retail investors lost while even lesser gained in this equity ride. The
only investors who made money in the rally are banks and trusts who earned money in margin loans and
brokerages that aggressively churned the portfolio and speculated on behalf of investors the portfolio. Chinese
stock market is still up by 70% which is by far the best return for a major economy. 1China still remains one of the
best markets in terms of alpha and is one of the lowest correlated markets globally and thus a very good index for
diversification in your stock portfolio. Compared to S&P 500 which has crossed its peak of 2007 when the
valuations were really high, CSI is still below its 2007 level and at PE of 17 justified compared with S&P 500 PE of 15
since most of the companies listed in US make their incremental revenue from emerging markets primarily China
and India.
5Further MSCI has recently announced that it will include A shares in its global benchmark indexes. This will result
in billions of dollars of investment in A shares going forward.
Moreover, one of the most important factors is that due to government strict regulations to curb shadow banking
and with falling yields in wealth management products, investors started investing in Equity markets WHICH
HELPED EQUITY MARKETS TO RISE in 2014-2015. This is also bringing the risk free rate lower and hence fairly
valuing A share market in Mainland China.
5 Results of MSCI 2015 Market Classification Report
a https://theconversation.com/how-chinas-bull-market-could-bleed-into-its-economy-44570
Performance of SSE vs HSI
Source: Google Finance; HSI in red colour
If you look at the past data and compare the spreads of SSI (Shanghai index) and HSI index, you will see that
whenever the spread of SSI over HSI increases to a very high level it converges. The spreads between these two
stock exchanges will always converge to average levels and hence this proves technically that the rally in A shares
was not sustainable and markets have seen correction. SSI is still elevated compared to average historical levels
since SSI has been undervalued for a long time.
In 2007 the Chinese stock market was trading at higher PE levels and fell much harder and it still did not result in
any recession. As a matter of fact during the same time United States and Euro area were performing poorly and
were in recession. Considering that both of them are biggest trading partners of China, China still grew between 7-
10%. Globally the situation is much better now with both United States and Euro growing with 2-3% with much
better macro outlook and therefore the downturn in the stock market is hardly going to affect China and world in
general.
China still has one of the highest savings rate like India and one of the very few economies which is not living in
excesses. This is a critical macro factor highlighting stability of an economy.
Going forward as Chinese equity markets become more efficient, driven by institutional trades and becomes more
efficient in allocating its resources, it is going to become a very important part of Chinese economy.
The Real Value of China’s Stock Market has made a very accurate estimate that China equity markets importance
going forward in Chinese and global economy.
This might be however a very good time to enter China in a phased manner to find value stocks with long term
view.
Intervention
Every country has a right to defend its stock market and has been done my many economies like United States in
banning short sale on selective stocks during credit crises, Hong Kong successfully defending its stock market and
currency peg during George Soros raid ( George Soros actually admired and congratulated Hong Kong for its
intervention and defence). A lot of press coverage was devoted in the last month to Chinese government
intervention in the market which as you read in my humble opinion was justified. President Xi Jinping and Premier
Li Keqiang (an economist by education) are primarily responsible for economic and social stability and to steadily
implement sustainable reforms. Many times it seems that any negative news is hyped and blown out of proportion
coming out of Asian economies especially China and this could be because China is fast becoming a superpower
and maybe people have misplaced conception about China and its economic policies. Equity market and real estate
is a bellwether of country’s economic performance and crisis but only in developed economies where the free float
of stock market is 100% of the GDP and stock market has a penetration of 50% and above. This is true in case of
United States since any downturn would lead to a much larger spill over in banking system and reduction in wealth
and consumption. However in case of developing economies like China, India or Brazil the scenario does not hold
true because of limited free float and retail participation in equities.
As mentioned above Chinese stock market in terms of trade is driven by retail investors (individual investors) with
only 6% of them having college education and 900% churn in stocks. ( Data for Chi Next)
If the markets in terms of trade were dominated by institutional clients then would have made sense for the
markets to decide the level of stock market. However as we have seen that is not the case. Markets have always
been irrational and usually very irrational investors come at the peak level of stock market and are the ones who
create a lot of panic once the markets turn. Although it is not right to protect such investors but it cannot be done
overnight and government in the end has to step in to avoid unrest.
Therefore it was prudent to intervene in the markets since retail or individual investors are prone to panic. On the
top of that margin calls and highly speculative behaviour would have further deteriorated the market and would
have fallen much more. The case of 1987 crash in US is an example. Although I do agree with Mark Mobius that the
Chinese government intervened too soon given that the markets were already 150% and maybe an intervention in
a phased manner would have been much better considering that even if the markets had fallen much more there
would not have been any spill over effect in the economy. Chinese government came out with blazing guns in
commando style and as we can see the intervention substantially calmed the markets and halted the fall in
equities.
Although markets could still go down and have gone down but the process has become slow and the panic has
disappeared. Reducing interest rates in China is easy since inflation is low and this gives government a lot of
manoeuvre to add liquidity in the system.
Some of the measures including buying index ETF and increase QFII quota were very well thought off. Banning
short selling is always good in case of panic meltdown, however it had a very limited effect in China since short
selling is limited to very liquid large caps stock and it is not very easy to do the same. Temporarily banning IPOs is
win-win situation for both investors and companies in such a scenario. Looking back world should look favourably
at Chinese government’s intervention and maybe it could be a very well deserved case study in macroeconomics.
Recommendations
Rework the structure of equity markets by implementing regulations which discourage speculative trading
especially by retail investors and structurally develop institutional trading through asset managers. One way is to
develop mutual fund industry along with ETF. This will help increase in penetration of retail investors i.e. (Increase
the breath of retail investors) while curb speculation since fund managers are better informed and educated at
investing and tend to hold stocks from medium to long term. Mutual Fund industry helps to diversify portfolio by
allowing retail investors to invest in more companies and limits speculative trading. Speculation in stocks never
helps and long term holding in stocks should be encouraged since stock return is both a measure of dividend
earned and stock appreciation. Long term holding is mutually symbiotic relationship for both the investor and the
company.
“Reducing and limiting margin trading and loans for retail clients. Although the regulations especially in trading in
stock futures are very strict, margin loans for equity trading should not be allowed to retail clients whose trading
amount is below a permissible limit and more tuned with their education.HNI with investable surplus of USD 0.5 mn
or above could be allowed margin loans for trading in shares just an example to illustrate”
Raising quota though QFII route will surely help in making the markets trading more driven by institutional
investors. China can easily slowly in a sustained manner increase the QFII limit to maybe 10% since as more global
asset managers come to China, so will it help the domestic asset management industry in China in terms of stock
coverage, better risk and technology knowhow which would lead to better information dissemination. Even if the
QFII limit is raised to 10% over a period of time it is not going
“Stricter KYC rules especially for trust accounts which sell wealth management products”
Capitalism says that markets should decide the outcome but recent history shows otherwise
Credit Crises: The damage in credit crises could have been limited had Lehman Brothers been saved. Henry Paulson
regretted his decision since he presumed Lehman Brothers was not a systemic risk. Lehman crises precipitate into a
global meltdown and resulted in huge tax payer’s money to bailout firms which acted in absolute greedy manner.
So ultimately capitalism resulted in free lunch with billions of tax payers’ money being invested in institutions
which were too big to fail.
LTCM (Long Term Capital Management) crises, a well known hedge fund which included the smartest people on
Wall Street including two Nobel Laurtees Robert Merton and Myron Scholes also collapsed and its huge leverages
almost brought down global markets. Since LTCM was considered a systemic risk and a timely intervention by FED
and major investment banks helped precipitate crises which could have been much worse. Its story is documented
in the book When Genius Failed by Roger Lowenstein.
Afterthought
It is not clear what is right or wrong since economics is not law of nature (apple falling down is... i.e. gravitational
law) and behavioural economics is still an evolving science due to the fact that no one completely understands
how a mind works. Saying that the emergence of behavioural economics as a branch of economics is very
important since it helps to understand human psychology with regards to economics and the results could be
amazing. When you deeply understand life and happiness you will realise that you live all your life in relative terms
and not on absolute terms. Real life works in theory of relativity, what could be right in US might not be the right
solution in China or any other country. Life and economics is an ever-changing flux which needs customised
solutions over real time and what could be good in one country need not be the perfect solution in economic terms
for another nation....
But time and again markets have shown that they are mixture of both rational and irrational behaviour. In the
documentary Inside Job, it was well documented the excessive behaviour of many traders on Wall Street. A leading
psychiatrist also stated that one of the worst addictions is the addiction to make money since it involves activity in
the same part of the brain where usually all excess in human indulgence lie.
Problem is that it is very difficult to regulate Greed and according to Gordon Gekko in the movie Wall Street “Greed
is Good” is the mantra in today’s world. Until we come out of this behaviour, crises are going happen again and
again..........................................................................................................................................................................
Chinese government has been very proactive in addressing economic concerns such as shadow banking,
introducing pro economic reforms in capital markets and its intervention in the market was very decisive and
justified. It is very clear over the past few years that Chinese government is best aware of the situation in China
rather than many asset managers and writers around the world. Hopefully the reform process will keep happening
and to quote great philosopher and humanitarian Confucius “ It does not matter how slowly you go so long as
you do not stop”
On a lighter note hopefully the reforms will be faster like it has been for the past few years
Nishant Malhotra
Disclaimer: Nishant Malhotra has no exposure to any equity stocks in China and has not been involved in any recommendation of stocks
in China as a professional. The view expressed is solely of Nishant and he has not received any funding towards the article. Whole or part
replication of the above would amount to plagiarism. The article is a based on qualitative research and fundamental research. I welcome
your comments and can be reached at [email protected]. Any disrespect for anyone is not intended and unintentional
Nishant is an experienced and highly qualified Investment Professional
with 8 years’ of progressive and diversified managerial experience. 6 years’
of banking experience with 5 years’ in private banking both in domestic
and international markets. Nishant also taught courses in finance as a
visiting professor in Business Schools in Pune including SIBM.
Nishant is a double MBA; MBA from CEIBS, China Europe International
Business School, Shanghai, a leading global business school, including an
exchange at Nanyang Business School, Singapore & MBA from Symbiosis
Institute of Business Management (SIBM-2002), Pune, India.
Nishant is a fitness enthusiast and does weight training, cardio exercises
and plays outdoor sports. A spiritualist, he is driven to change the world
for the better and is always keen to involve in social causes and practises
mindfulness meditation and yoga. He can be reached at
[email protected]. Nishant is presently based in Pune, India with his
parents and works as a freelancer specialising as a consultant in asset
management industry.
