Crack in the Great Wall of China: Chinese Saga.

Crack in the Great Wall of China: Chinese Saga.

The plunge in china’s stock market has sent shock waves around the world and amounted for real time stress test for the country. The current volatility, which is not very desirable, represents a natural market correction from its June 12 peak of 5,166, the Shanghai composite index had climbed 150% over the past twelve months. Intervention by the government authorities by allowing 1300 firms to suspend trading stopped the sudden slide and the market closed on July 14 at 4,159.

The Chinese displacement factor was the emergence of the country’s own internet economy was the first phase, with the spectator success of companies like Alibab millions of Chinese investors become convinced that tech stocks would make them rich in no time and they stated investing huge amounts of money in all sorts of fancy eCommerce companies.

The second and third phase was over trading and monetary expansion. Registered as well as unlicensed security brokers and lenders were proving large amounts of margin funding which resulted in surge in prices for the stocks and also increase in trading volumes which resulted in the valuation so be stretched to an abnormally high levels. Moreover in order to adjust to the slower GDP growth, the central bank cut interest rates resulting in monetary expansion. Face with the relatively low interest rates that were on offer in form of fixed deposits and high property prices the local Chinese savers viewed the stock market as the best option resulting in growth in the price of shares and further increase in trading volumes.

With the huge correction in the stock market it proved the point once again that highly leveraged stock markets are unstable and unsustainable. The Chinese government played a huge role in development of markets which was not a wrong move, at the end of 2013, when the Shanghai index was at 2,116, the Chinese debt markets amounted to 256 percent of GDP and stock market capitalization was 36% of GDP, the leverage ratio fell to 2.6:1 closer to 2.2:1 in the United States. Where the stock market capitalization was 132% of GDP.

China’s foreign exchange reserves have dropped for four straight quarters, leading   to renewed warnings about capital outflows.

Interpreting capital flows has long been a favorite game for Chinese economy watchers. An analyst’s view on hot money outflows is often an indication of his or her broader stance towards the world’s largest economy.

For those who believe China’s economic slowdown is worsening and risks from spiraling debt and wasteful investment are propelling the country towards a financial crisis, the specter of capital flight lurks behind each new data point. They view capital outflows as a sign of waning confidence in China, and they warn that outflows will drain liquidity from the domestic economy, making it harder for companies and local governments to raise funds.

The other side the investors who are bullish and optimist about the Chinese market prospectus believe that moderate capital outflows are a sign that China is liberalizing capital controls and abandoning its mercantilist obsession with accumulating foreign reserves.

With the Federal Reserve preparing to raise interest rates and the Chinese stock market suffering big losses, capital flow trends have taken on even greater importance. Higher US rates are likely to draw capital out of China and other emerging markets, which could place even greater downward pressure on Chinese share prices.

After hitting an all-time high of $3.99tn at the end of June 2014, reserves have fallen by $299bn.  The net capital outflows in the second quarter alone totaled about $200bn. And estimated that capital outflows estimated to $520 bn combined over the past five quarters.

One is a shift in China’s foreign exchange holdings between the central bank and the private sector. Until recently, the (People’s Bank of China) PBOC held almost all foreign exchange within China as official reserves, while banks, companies, and households held little.

This was due largely to the central bank’s intervention in the foreign exchange market. At its peak, the PBOC purchased hundreds of millions of dollars a month in order to restrain Renminbi appreciation. Chinese banks and companies, for their part, were happy to fob off their dollars on to the PBOC, since they stood to profit from slow but steady Renminbi appreciation between 2005 and 2013.

 That changed last year, when the Renminbi suffered its first significant full-year depreciation in more than 20 years. Now many Chinese exporters who receive payments in dollars simply hold them, rather than buying local currency. Though these dollars no longer swell the central bank’s coffers, the money remains inside China and so should not be viewed as outflows.

Numbers of economists expect mild capital outflows from China to continue, but most analysts do not see cause for alarm. They note that China’s foreign exchange reserves are still by far the world’s largest and that a significant chunk of capital outflow is due to intentional policy choices by Beijing, rather than panicked investors seeking to withdraw. While China has liberalized capital flows significantly, remaining controls still severely limit the ability of investors to transfer large sums abroad.

  

One of the reasons by the Chinese government really pushed for market reform and encouraged the local companies to go public is the  Chinese companies like many other counterparts elsewhere in the world are by no means transparent allowing shareholder scrutiny of any significance. There are other two reasons that the governments obvious desire to promote share market growth. The first is the sheer symbolism of a buoyant share market that gives a signal for a good and flourishing economy. The second is the need for a vehicle to privatizing public ownership in the economy.

These are some of the reasons that the Chinese government had taken steps to boost the markets almost quarter century ago. China’s experiment with the markets was cautious only a few companies were allowed to list.

Shares were split in two kinds A- shares denominated in Renminbi (RMB) and B shares in US or Hong Kong dollars.

Till 2000, A share market was not open to foreigners and B- shares to domestic investors. . It was from 2001 the government effort to give stock markets an important role in the economy began.

The government chooses to spur the market by allowing individual Chinese investors to invest in B shares and chosen foreign institutional investors to invest in A- share market.

But the real boom started in 2006 where a second set of reforms were adopted more companies were allowed to list themselves in the stock market and so called non-trad able shares were phased out and a one year ban on IPOs was lifted.

Moreover rules were relaxed making it easier for foreign companies to buy A- shares in large volumes. With rules in the then fastest growing economy relaxed China became the new frontier for international finance. IPO’s by bank of china and Commercial Bank of China, two of the country’s largest banks were a roaring success mobilizing more capital than expected and evincing huge investor interest.

The Chinese government is now monitoring the market situation very closely and trying its best to support the markets in order to prevent a very sharp crash as the fall in the Chinese markets the rumble can be felt around the globe and in the current macro-economic situation any further damage to the Chinese markets and worsening of the macro-economic situation would hurt the overall world stability and growth prospectus.  This support and government intervention seems the most sensible and logical move in the current context.

       -Farzan Ghadially