Why the volatility in Chinese markets is more political than economic

China’s stock markets have been mockingly compared to casinos and the game of roulette. The previous week showed why. Trading halted in a matter of 15 minutes on Thursday, January 7, once the CSI 300 – an index representing the performance of stocks traded on Shanghai and Shenzhen stock exchanges – tanked seven per cent activating the circuit-breaker. Last year, CSI 300 fell 8.5 per cent on a day termed “Black Monday” by Chinese media.

If the crashes are intimidating, the surges are luring – the same index had climbed 150 per cent in the year starting June, 2014.

The latest crash also hit the global stock markets. Fears of a Chinese economic slowdown meant markets such as FTSE, DAX, Dow Jones and BSE tanked by considerable margins.

Seesaw movements in stock markets are nothing new, but the Chinese markets have perplexed even the most seasoned investors. Clearing the air about the Chinese stock market requires answers to two crucial questions:

1. Why does it show such erratic movements?
2. What is the meaning and implication of these movements for China?

Reasons behind the erratic movements

Thanks to government intervention, in the strictest sense of the word “market”, Chinese stock exchanges are not markets at all. A market is characterised by the freedom to move up and down depending on investor sentiment, with little government interference. This is not the case with Chinese markets, on which the government has staked its credibility – reducing them to the bellwether of its reforms for a market-oriented economy. These reforms include relaxing capital controls and letting Yuan levels be determined by market forces. For the government, a robustly performing stock market indicates that the people have more faith in its reform agenda.

Since the Communist Party cares foremost about its credibility, the entire government machinery – from state-run newspapers and top leaders like Li Keqiyang to even elite university students – talked up the apparent benefits of investing in Chinese stocks, leading to massive bubbles being created.

To encourage people to invest, the messaging went far beyond words. The Chinese government followed a loose monetary and fiscal policy, relaxed regulations on number of accounts allowed per investor (which went from 1 to 20 in April, 2015) leading to a massive upsurge in new accounts and trading volumes, and strongly encouraged margin trading (borrowing to buy stocks), all of which stoked the equities bubble. According to Wharton professor Franklin Allen, the upswing in the market starting June, 2014 “seems to be a liquidity-fuelled bubble made possible by extensive margin loans”.

The bubble is exacerbated by the composition of investors in Chinese markets. Unlike Western capital markets, which are largely controlled by deep-pocketed institutional investors, Chinese markets are awash with capital from small, relatively unskilled investors. Due to inherent volatility, fraudulent practices, and limits on trading in the so-called A-shares listed on Chinese exchanges, it is estimated that only about 1.5 per cent of these shares are owned by foreign investors. Most Chinese investors are opportunistic, looking to make a quick buck. To them, panic and excitement come in equal measure. Their investments are driven by signals from the government.

In this piece, commenting on the fickle-minded Chinese small investors, Wharton Professor Minyuan Zhao says, “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,” and later holds them liable for causing market volatility.

The third chart from this link should dispel any notions that the Chinese markets exhibit remotely normal behaviour. As further evidence of the bubble, the same shares listed in mainland as well as Hong Kong exchange were at a considerable premium in the former, at the peak of the bubble.

What’s more interesting is that the biggest bubble was created largely in ChiNext – a group of start-up, largely technology-driven, stocks. According  to The Economist, “ChiNext is supposed to be China’s answer to Nasdaq. At the moment it looks like precisely that in 1999, just before the dotcom bubble spectacularly burst.”

There is also strong speculation that the government inflated the bubble to help the debt-saddled state companies carry out in what would essentially be, according to Wharton Professor Marshall Meyer, the “world’s biggest debt-equity swap”. This means that the companies could pay off some of their debt by selling their highly-priced shares. The government tried to cook up a dream scenario where the state companies would be free of the debt burden, and the investors would be better off as well. As the latest crash shows, this win-win situation remains the stuff of dreams.

The first major correction to the bubble came last year, on account of signals that the government wasn’t doing enough – by not further loosening monetary policy – to support share prices. The slump was led by relatively wealthy investors. Markets lost 30 per cent in a matter of three weeks. Due to relaxed capital controls and waning confidence, the crash was accompanied by flight of foreign capital. More than the investors, this spooked the government: PBoC reversed its prior decision to allow Yuan to float freely, the government imposed stricter capital controls, suspended trading, debarred big investors from selling their shares en masse, arrested many over accusation of fraudulent trading, and in a death blow to its reform agenda, it pumped in over $230bn in the markets to re-inflate the bubble. To counter the sharp slide in Yuan triggered by record forex outflow, PBoC burnt through several hundred billion dollars of reserves last year. Yuan, and thus the forex reserves, continue to be under pressure.

Instead of calming investors, government’s reactionary policy only undermined confidence in the markets, setting the stage for the second correction, which came in the first week of January. Further, the circuit-breakers, instead of calming investors, might have accelerated the mad rush to dump stocks by exerting a so-called ‘magnet effect’, which encourages investors to sell shares before trading halts. For S&P500, circuit-breakers are much better spaced out at 7, 13 and 20 per cent to avoid precisely this effect. Besides, American markets are far more mature than their Chinese counterparts, and even a 7 per cent drop would be a rarity. On the other hand, Chinese markets often saw 5 per cent drops during regular trading days before the circuit-breaker was introduced. The magnet effect kicked in when investors realised they had little time to sell before the market closed for the day. Recognising this folly, China has suspended the circuit-breaker.

What are the implications for China

Instinctively, such large and recurring crashes in stock markets seem like a statement of doom for the Chinese economy. But just as the bubbles were not grounded in economic reality – good or bad – the crashes are largely disconnected from it too. This is asserted by the economist Eswar Prasad, as well as by a paper co-authored by Wharton professor Franklin Allen, according to which stock market returns in US, UK, Japan, Russia etc. are strong predictors of GDP growth. Further, the paper says. “The correlation between market returns and future GDP growth for China, however, is much lower and statistically insignificant.”

This is largely because unlike Western countries, where stock market capitalisation is over 100 per cent of GDP, China’s stock market capitalisation is only about 40 per cent of its GDP. Further, The Economist reports that less than 15 per cent of household financial assets are invested in the stock market, compared to much higher shares in Western countries. Firms are far less dependent for financing on stock market than on debt. According to The Economist, the debt in the system due to margin trading is only to the tune of 1.5 per cent of banking assets, which does not pose a systemic risk. However, there are contradictory views on this, here and here.

There is a possibility that the crash will impede the growth of China’s financial sector, which has been playing an increasingly important role in the country’s growth lately.

The volatility in Chinese markets is actually much more a political statement by investors against the government than an economic one. The incessant flip-flops of the government, and its failure to boost markets despite its desperation, have raised questions over its will to introduce market-oriented reforms as well as its competence. Investors fear that the government will abandon its “crossing the river by feeling for stones” (a phrase coined by Deng Xiaoping) policy towards liberalisation and intervene heavily in the markets as and when it sees them deviating from the script, which means serious investors, including foreign ones, will probably keep out, leaving the opportunistic ones to wreak havoc.