Ahead of the curve: Is there a bull in the China shop?
The rise in Chinese stocks up more than 60% since late 2014, propelled by an explosion in margin trading, has raised concerns about a bubble, and that it will burst. Nevertheless, research shows that an asset bubble can last for an undefinable period, ranging from weeks to years. Currently, there is no evidence of China’s margin debt growing to a dangerous level that could trigger a market crash or of the stock market developing into an unsustainable bubble. A recent macroeconomic policy shift by Beijing designed to contain the downside risk of growth could sustain the market boom for a while longer.
An increase in margin trading is not a reliable indicator for market crashes. For example, although margin trading led to sharp market corrections in the US in 2000 and 2007, there have been many occasions when a sharp rise in it did not lead to a crash. We do not know, ex ante, when and if the level of margin debt has reached a critical level.
Jumps in overall stock market leverage are perhaps more relevant to assessing the chances of a Chinese crash. Leverage often accumulates invisibly; margin debt is just one factor. For example, during 2005-07, leverage built up on corporate balance sheets – especially unlisted state-owned enterprises – which was collateralised and the proceeds used for stock market punting. This time, players are using shadow banking.
The trouble is that we do not know how and where speculative leverage is building and when the red line will be crossed until after the event. However, putting the recent A-share market boom into perspective can help to assess the bull run.
First, the Shanghai A-share index and the number of new investor accounts are half their 2007 levels. The latter not only has a correlation with the movement of A-shares, it shows that only half of the investible funds have entered the stock market, compared to the last cycle.
Second, despite the recent slowdown, China’s nominal GDP has grown by 3.5 times since 2005, the onset of the last stock market boom. On a macroeconomic basis, this argues the increase in stock prices has not been a bubble and that the leverage has not all gone into stock market punting.
“The key issue affecting the outlook for Chinese stocks rests in the deflationary risk. China’s PPI has been in deflationary territory for three years”
The key issue affecting the outlook for Chinese stocks rests in the deflationary risk. China’s PPI has been in deflationary territory for three years. Nominal GDP contracted in the first quarter of this year with the GDP deflator turning negative for the first time since the sub-prime crisis. In fact, China has seen a negative output gap since 2011.
Hence, real interest rates have soared, creating a downward economic spiral by reducing investment appetite, aggravating deflationary pressures and eroding investment sentiment. In the absence of any supply-side structural reform, monetary easing is the short-term option to break the downturn.
Arguably, Beijing was slow in realising this, as it focused on deleveraging the economy in 2014. The interest rate cuts since last November show that Beijing has recognised this risk and shifted its policy focus from cutting debt to protecting growth, and from containing inflation to fighting deflation.
While the rise in margin trading is a concern, the change in policy is more important in shaping the equity outlook. Weak growth and deflation risk will put pressure on Beijing to adopt a policy-easing bias to reduce systemic risk. Stock valuation may be a secondary concern for Beijing at this stage, as it sees a strong stock market as a facilitator for capital-market reform by reducing the reliance on banks for corporate funding on banks. This benign policy backdrop plus rising momentum can propel Chinese stocks further.