In my Bloomberg TV interview from earlier today, linked here, I discuss the preliminary popping of China’s equities bubble. Trading of nearly half of China’s listed companies has been suspended, and I believe it very likely those shares will continue to fall once the suspension is removed. These are challenging times for China.
I’ve been getting a bit of undeserved praise these past couple of weeks for my assertion on CNN and in my blog on June 19 that China’s stock markets were a bubble destined to pop. Undeserved because my prediction was merely based on the simple recognition that the forces of gravity apply in China just as they do everywhere else in the world.
At that time, average price to earnings valuations of Chinese stocks were triple that of any other significant market and it was clear that these valuations could not be supported under any realistic assessment of China’s future growth. Under normal circumstances, the market losses of the past few weeks would be seen as a natural and healthy response to unsustainable — and government-fueled — mania. But rather than allow these losses as a natural part of the market cycle, the Chinese government has seen them as a systemic risk and essentially gone nuclear in its response. In the past two weeks they have required government-connected pensions, the sovereign wealth fund, insurance companies, and brokerage house to make massive purchases of shares, cut interest rates, banned short selling and selling by large shareholders and managers of listed companies, restricted IPOs, backed up margin loans, and allowed the suspension of trading of approximately half of all shares.
This aggressive of a response only makes sense if they know something the rest of us does not about the vulnerability of their economy or if they see their political system as being so fragile it cannot withstand even a relatively small economic hiccup. With half of the shares frozen and such a massive effort to bolster the prices of the largely state-connected blue chips still being traded, it is not at all surprising that the indexes have rallied these past few days. But it once again defies logic and gravity to assume that the average Chinese retail investor (and 80% of investors there are retail investors) will not try to sell their currently frozen shares once they become liquid, no matter what happens with the rest of the market. It also seems extremely likely that a declining market will ensnare many more margin investors who borrowed money to invest but will need to sell equities or other assets to pay back their lenders in a declining market.
China took a big gamble in pushing equities so aggressively on the Chinese public. If the stock markets had gone up in a stable and sustainable manner, they could have used the equity value increase as planned to swap SOE and other debt for equity, get capital to small and medium enterprises, and foster consumption. Instead, by encouraging the insane bubble to grow ever larger and panicking when the bubble began to pop, Xi and company have now staked the government’s credibility on the maintenance of market levels that still don’t make sense (now 2X the average P/E valuations of the highest other markets). It is a lose-lose for Beijing. If they maintain the markets at these levels, they will encourage further speculation simply not supported by the underlying valuation of most Chinese companies. If they let the market drop to a sustainable level, they will lose the confidence of an important part of China’s population, especially now that they have staked so much on puffing up the indexes.
The sad thing about all of this is that China’s economic reforms under Xi had previously been moving in a positive direction. As distasteful as the government’s crackdown on alternative voices seemed to many outsiders like me, China was making progress towards enhancing consumption, rebalancing the business playing field to support SMEs and limit the power of SOEs, and letting resources be allocated more by market forces. As I always say, however, the ultimate misallocated resource in China is political power, and when the market turn even hinted at potentially threatening the position of the party, Beijing decided to go all in to support the SOEs while essentially hanging the SMEs and retail investors (whose shares had already bailed out the SOE debt problem) out to dry. It’s a very bad sign for Xi’s reform agenda, and it would be a real tragedy if China ended up sacrificing the preliminary levels of openness achieved in the Hu/Wen years without receiving the market promised reforms.
China’s leaders are remarkable in many ways, but it remains a big mistake to assume, as many observers do, that they have such a sure hand the forces of gravity no longer apply. China’s overall economy is still in decent shape today, but its future, among other things, depends on reform along the lines Xi and his team have outlined. Many of China’s particularly smaller and tech-oriented listed companies remain overvalued and China will be better off if the stock markets reflect more sustainable valuations. But if market reforms become stillborn due to Beijing’s heavy-handed response to the stock losses, I predict that Japanese-style stagnation awaits China in the medium term.