Ten Lessons from China’s Equity Market Turmoil: What is Real?

The Chinese stock market has been on an unprecedented rollercoaster: up 150% in six months, down 30% in four weeks and then back up 18% in two weeks following massive government intervention. Between the peaks, 10 trillion RMB of market cap had evaporated, about the size of Canada’s annual GDP, or Russia’s. What is more, with many of the government’s measures only temporary, it is unclear where and how the equity market will stabilize over the medium term. What is clear is that the market needs improved mechanisms to ensure stability and orderly functioning. Crashes are not unusual and the US has demonstrated its leadership in this too with the unravelling of its banks and the ensuing Global Financial Crisis. It revealed that the sub-prime lending industry and the securitisation and leveraged financing sectors associated with it were not “real”, but flawed concepts not what they purported to be in terms of value and their underlying risk-return profile. What is also clear is that the spiked growth of China’s stock market in the last six months bucked the economic reality of lower growth and higher risk. China’s stock market has proven in dramatic fashion that it is not “real”. Similarly, for a long time, the GDP growth of China has not been “real” given that it largely consisted of fixed asset investment growth of up to 30%, with funding being applied to projects of questionable long-term economic returns. The question for China is whether its capital markets yet provide a reliable basis for financing its plans for its political and economic agenda. The more important question for foreign observers is that, if the currency is fixed so is not “real”, if GDP growth is not also “real” and the stock market is not “real”, what else may not be real? This question can have a dangerous overspill for China when applied with the same scrutiny to China’s political ambitions, its positions in its many territorial disputes, its demand that the global community respect its UN veto and many other of its most important issues. The events of the past month provide some important lessons for political and economic analysts, investors and the Chinese government in this regard.

The A-share market kicked off its rally in earnest late last year, following several years where the Shanghai Stock Exchange was the worst performing major bourse in the world. The market’s bull-run was triggered by monetary, rather than market policy. Slowing GDP growth in 2014 triggered China’s central bank, tof the market.he People's Bank of China (PBOC), to lower interest rates and relax the reserve ratios for banks, thereby easing credit to stimulate the overall economy. As the equity market subsequently picked up due to the availability of easy credit to fund stock purchases, the PBOC also injected liquidity into the market and encouraged margin lending by brokerage firms to drive further liquidity. These measures led to a ballooning of leverage in the stock market, with stocks bought on margin approaching 10% of the free-float of the entire market, a world record.

Meanwhile, market pricing levels made it clear that the peak was a speculative bubble: GDP growth is continuing to slow and corporate profits are actually lower than a year ago, providing no fundamental driver for the increase in share prices. Meanwhile, the turnover of Chinese equities doubled, with average holding periods of stocks down to 15 days, indicating the speculative nature of the market.

When the bubble burst in early June following the CSRC’s attempt to curb margin lending, the government tried to stem the tide with a series of increasingly drastic measures, only succeeding after suspending trading of over half the stocks on the exchange, locking up major shareholders and funding a massive buying spree by securities firms and state-owned companies. These measures drove a massive rebound in the markets, while the government sought to balance the need for liquidity to support the market and reduce leverage in the system through a series of measures that appeared to be at odds with each other at times. While Asian equity market crashes and governments acquiring shares to prop up prices are well known phenomena, the roller-coast of the A-share market and the sheer breadth of the government’s interventions make it unique, and recent events provide a series of important lessons for China’s leaders and investors in the region more generally.

Lesson One: “It’s the Stock Market, Stupid”.
The performance of China’s stock market is, like that of the overall economy, a test of legitimacy and credibility for the Chinese communist party. In the absence of a democratic referendum, the party has sought to base its political legitimacy on social stability and continuous wealth creation.

“The government has been sending out strong messages that it will bail out the market over the past few days. But given the on-going free-fall, the government's power seems to be not as great as previously expected.”
Global Times July 4, 2015
While stock ownership penetration among households in China is still low at 15%, there are now over 90m retail brokerage accounts in the country, more than there are communist party members, making equity markets an important part of the overall wealth creation framework. As the guarantor of wealth creation, the party cannot allow the market to crash, and moreover, having started to intervene, must follow through decisively with what means necessary to maintain credibility. The lesson is that when you need to do what you say, you should be careful upfront about what you promise. The second lesson is that the market is not something you can control without massive consequences to participants, you risk generating a huge number of damaged and dissatisfied constituents when you do intervene and this number grows as the participants grow.

Lesson Two: The Invisible Hand of the Market Meets the Heavy Hand of the Government. China’s leaders during the crash have demonstrated that they will do whatever it takes to stabilize the market. When initial lighter touch interventions proved to be ineffective, the government introduced increasingly heavy-handed measures to arrest the slide in stock prices, effectively signalling that it would defend the market with any means necessary .

While the knowledge that the market is deemed ‘too big to fail’ is useful for investors, the regulatory uncertainty created by the government’s willingness to stop at nothing to protect the market coupled with the absence of known measures that the regulator may apply creates unforseeable risk and threatens the viability of the equity markets for long term investors and leads them to cede the stage to speculators. This has the potential to undermine the role of the equity market as an efficient allocator of capital.

Lesson Three: As in the Market, so in the Economy. One of the key drivers of the Chinese government’s unconditional underwriting of the market is the fear than a crash would spill over to the real economy. Margin lending and the use of stock as collateral for loans, both widely used in the recent bull run, are transmission methods by which stock market performance impacts affects the wider economy, at a time when China is trying to rein in a credit bubble and fight over-leverage.

The question of how significant this impact is remains debatable though. The six-month bull-run of the market did nothing to spur China’s slowing economy, which conversely held steady in the second quarter of this year when the stock market crashed. Indeed, the market actually dropped when the government announced that Q2 GDP growth exceeded forecasts, presumably on the assumption that recovering growth removes the need for further stimulus. Further, the estimated RMB 4 trillion of loans that have gone into equity markets are a drop in the ocean compared to the RMB 120 trillion of total leverage in the financial system in China. Moreover, the risk of contagion into the banking system is also contained for the time being at least; the securities firms that have directly and banks that have indirectly, through structured financial derivatives called "umbrella trusts", lent money to investors are still protected since any losses are first absorbed by the borrowers before impacting the lenders.

Lesson Four: Irrational Exuberance, with Chinese Characteristics. While margin lending may have provided the fuel to drive up prices, the rally itself was driven by what has in another time and place been deemed as “irrational exuberance” rather than by any economic reality. This rally was further driven by vocal support from vested interests that saw retail investors flock to any IPO and tech stocks in particular as ‘sure things’, with companies seeing strong share price gains simply upon changing their names to ones that sounded like dotcom companies. What is less focused on today is that the Chinese government itself was on of these vested interests.

A booming stock market provided a welcome alternative to debt for recapitalising state-owned enterprises (and another effective wealth transfer from households to the state), while profits from share dealing provided a P&L boost to companies as operating margins shrank in the macro-economic slowdown.“The reason behind the rally is macroeconomic support for China’s development strategy and the intrinsic force of economic reforms”
People’s Daily April, 2015
Accordingly, none other than the communist party’s official paper, the People’s Daily, published an article titled “4,000 is only the Beginning” in April of this year, providing investors with the evidence that the rally was at least state-sanctioned, if not state-orchestrated. The lesson of interconnectedness seems an important one; China’s government institutions still come from an era where single levers deliver single outcomes while China today is much more intertwined. It is time for a re-examination of the system to better understand which levers are appropriate; and that is the slippery path to unwinding huge panoply of state control.

Lesson Five: Mixed Signals Shake Markets.
One of the reasons that the government’s initial measures failed to calm the market was due to the contradictory signalling coming from different government entities and regulators.. In the absence of the clearly stated policy, China’s central bank since November has alternately injected and withdrawn liquidity from the market. More recently, while the PBOC sought to stabilise prices by further cuts to the benchmark rate and reserve requirements, releasing RMB 470bn of potential additional liquidity into the market, the CSRC simultaneously stamped down on margin lending, reducing that liquidity’s ability to enable market entry. These mixed signals confused investors with regards to the government’s desired outcome and precipitated further sell-offs. While the Chinese character for ‘crisis’ may consist of the characters for ‘danger’ and ‘opportunity’, Chinese investors desire clear signalling no less than western ones.

Lesson Six: The Not so Hidden Cost of Intervention.
China’s government in its handling of the slide of the A-share market has clearly shown the decisive action it believed was needed. “By putting in these blockages and restrictions, it looks like the markets are artificial…It is imperative that China continues on its path of reform and liberalisation by allowing more people to participate”
Larry Fink, CEO BlackRock
However, this runs contrary to its much vaunted comprehensive reform blueprint announced in 2013, in which it vowed to let markets, rather than the government, play a “decisive” role in resource allocation. While stabilizing the market may have been necessary from a domestic credibility perspective, the government’s actions have cost it international credibility and threaten to put other more important reforms at risk, particularly the long term liberalisation of China’s capital account. Critics naturally fear that a government that cannot deal with a free equity capital market will be unlikely to tolerate a freely floating currency,which has a much bigger impact on the China’s economy. Measures such as trading suspensions are capital controls by another name and, as many fear, harbingers of things to come.

Lesson Seven: Investors Have Options, and Make Choices.
China’s A-share market turmoil has clearly impacted (market-) unrelated assets such as US listed China stocks and the Hong Kong Stock Exchange, both of which saw heavy losses during the general China sell-off, despite the fact that neither had seen the same frothy gains. However, over the long run these asset may prove to be winners, as investors compare different markets’ performance, transparency and the quality of regulation in times of crisis and find China wanting. Hong Kong is a clear potential beneficiary of this analysis, and many international investors have fled the A-share market in search of safer waters, with nearly RMB40bn in international funds flowing out of the Chinese market through the HK-Shanghai Stock Connect in the first week of July alone. While domestic investors’ options for offshore investments remain limited today, China’s planned ongoing capital account liberalisation will mean that the potential for outflows will only continue to grow if it fails to reassure investors of the stability and transparency of its equity markets.

Lesson Eight: Don’t Blame the Foreigners and Hedge Funds.
With the government unable to admit that the market’s peak was a bubble (partially of its own making), it is the market’s downward correction that needs to be explained as the anomaly. “‘Malicious short-selling of stocks and stock indices’ - an example of the dodgy practices many believe were part of the recent stock over the past few weeks.”
China Daily July 2015
As the market started to fall, government agencies began dropping references to collusion by foreign investors and the impact of short-sellers as the reason for the fall, and promptly banned latter. While the blame game is commonly employed by the communist party in China, the rhetoric used by the government was of the “capital running dog” variety typically reserved for political dissidents nowadays (or Japanese): various government organs spoke of the need to “strictly punish” “malicious short sellers” for their “illegal manipulations”, and promptly launched an investigation that found evidence of misdeeds, without specifying what these illegal manipulations were or who had committed them. While it is unclear whether these allegation provide comfort to China’s domestic investors, it is abundantly obvious that they have the opposite effect on international investors and the credibility of regulators as guarantors of a market with a level playing field to all.

Lesson Nine: Once You Start Fiddling …

In the course of its interventions to stabilise the stock market, the government’s own actions have had unintended consequences that have required the need for further corrective actions, themselves with unintended consequences, creating a chain of interventions that has put the PBOC and the CSRC on the back foot in reacting to events. The initial sell-off was partially triggered by the government’s curbing of margin lending, and the government’s own interventions to prop up prices created a liquidity crunch that have in turn required it to relax the curbs it had previously put in place. With China’s government lagging behind the curve with regards to on-going developments in the market, it will need to execute more and more, and increasingly severe reactive interventions to try to achieve a stable market with both low volatility and decent liquidity.

Lesson Ten: What in China is “Real”. Given the spiked growth of China’s stock market in the last six months bucked the economic reality of lower growth and higher risk, more fundamental questions need to be asked. China’s stock market has proven in dramatic fashion that it is not “real”. Similarly, for a long time, the GDP growth of China has not been “real”. Given that state owned enterprises still account for 30% of total GDP, growth is to a significant extent the product of an equation where mandated production plans have a heavy influence on the result. As we should know, when one looks at the GDP of what are predominantly free-market economies, the GDP gives some indication of the confidence to produce in the hope of making profits. This is not the case in government-dominated economies, where GDP is more often the indicator of the government’s need to maintain stability of employment or project growth as part of a political agenda. China still has the will to do both. So, why is the GDP falling? The fall in China’s GDP demonstrates the shift in mix away from the public sector and the failure of the government to deliver the promised reforms for the private sector and consumers to pick up the slack. The collapse of the stock market is the result of the same phenomenon; this time the artificial input was private speculation, to a rise that was not based on fundamentals.

The lessons above do not lead to a positive scorecard of China’s capital market and its government’s handling of the on-going turmoil. It is important to recognise though that government bail-outs are not necessarily a bad thing per se. Countries with mature capital markets such as the US and Japan have both directly and indirectly supported their stock markets when systemic risks have threatened the financial stability of the market. The US Treasury’s measures following the collapse of Lehman Brothers in 2008 fall into this category, with the bank’s insolvency threatening a complete breakdown of the equity market. China’s stock market bubble bursting, on the other, clearly does not. The market was still functioning effectively; sellers were simply outnumbering buyers following a bull run, where the opposite with the case."Life is a series of natural and spontaneous changes. Don't resist them - that only creates sorrow. Let reality be reality. Let things flow naturally forward in whatever way they like.”,
Lao Tzu 5th-6th Century BC
Moreover, the measures put in the place by the US government were designed to increase investor confidence in the market’s ability to function, based on trust, transparency, the rule of law and efficient regulations and enforcement. The events of the past month have clearly demonstrated that these features are all lacking or severely underdeveloped in the Chinese equity market. If China’s leaders can successfully address these issues, (all of which are part of its stated reform blueprint, it will not need to intervene in the stock market, which would then be allowed to do what it is supposed to do: efficiently allocate surplus savings to productive investment. Until this time comes, China’s A-share market will continue to be a risky rollercoaster ride many investors will stay away from.

When bubbles burst, so do the illusions that created and sustained them. The West has become accustomed to seeing China’s continuing rise as a given, paying respect well beyond the country’s current due with regards to its economy, its consumption power, its innovation, the quality of its labour force, the efficiency of its reforms and therefore its global power position.

Their outward protestations about being a developing country aside, the actions of China’s leaders demonstrate that they too have moved from simply accepting their position to insisting on it. The broader lesson from recent events is that if belief can move markets without a basis in fact, it is worth examining more closely the many fundamental assumptions underlying the inevitability of China’s rise to dominance. If China does not firmly ground its objective and policies in facts, its risks creating more bubbles across a wide range of issues, and the China Dream may too turn out be an illusion. The measured rise of China is slowly at risk of becoming very unmeasured. Similarly, if the West does not reassess its approach to engaging China to one grounded in facts, rather than assumptions and fears, it risks not just losing on its Chinese investments it risks creating a power that it cannot contend with. And that would create geo-political risks that are in nobody’s interests.


1.    See appendix for definitions and sources

2.    Paraphrased from the unofficial 1992 campaign slogan of Bill Clinton “It’s the economy, stupid”, whose campaign focused on the then prevailing US recession to successfully unseat President George H. W. Bush

3.    Former Federal Reserve Board Chairman Alan Greenspan, who ironically used the expression in the middle of the Internet bubble in 1996 to refer to the Japanese stock market