The relentless rise of China’s stock markets has become a big topic among market watchers everywhere, especially in Asia, where the value of shares traded on mainland China’ stock exchanges on Wednesday exceeded the entire value of stock trading in the rest of the Asia-Pacific region — including Japan. Analysts, economists and investors seem unanimous on the significance of this development. Opinion, however, is divided on where it’s all heading.
On the side of the bears, Goldman Sachs warned on Thursday that China stocks may soon face a “correction”, as earnings cannot justify the rally that has made them the world’s biggest gainers this year, reports Bloomberg .
“Current valuations are demanding and seem to have outpaced the improvement in market fundamentals,” analysts at Goldman, including Thomas Deng wrote in a report. The “risk of market euphoria is building up” among domestic retail investors if regulators fail to step up their efforts to contain market irregularities, Goldman noted.
China’s stock market is now worth more than 70 per cent of GDP, notes Stephen Green, senior economist in global research at Standard Chartered Bank — still below US/UK levels of 150 per cent of GDP but well above its 2001 level of 15 per cent. “This means it is beginning to have economic significance — though the speed of the ramp-up means that if there was a correction of 30 per cent today, the overall macro-effects would be limited. However, the pain would be concentrated among small investors,” he says.
A key factor driving small investors into equity markets is the government’s restriction preventing banks from offering deposit rates that exceed the central bank’s one-year deposit rate, currently 2.79 per cent. Inflation in March rose to a two-year high of 3.3 per cent, according to official figures.
Hence, as CLSA’s subscriber newsletter, Greed & Fear (G&F), observes, newly-opened (yuan-denominated) accounts by A-share retail investors grew by 191 per cent in March, while there were 4.49m newly opened A-share accounts in the first four weeks of April alone — compared with a total of 3.08m new A-share accounts opened in the whole of last year, according to China Securities Depository and Clearing Corp.
“The market is surely overdue some stock-market focused tightening measures from the authorities in the short term… But in the longer term, the A-share market seems heading for a full-scale mania, by which is meant a market trading on 50-60x forward earnings, as opposed to the current rating of 33x,” says G&F .
The only thing that can stop this — given the fuel represented by trapped liquidity, A-share listings of H shares and low deposit rates, says G&F, “is aggressive monetary tightening”.
But so far, the Chinese authorities have only engaged in token tightening. G&F’s conclusion is that “the authorities will remain reluctant to really tighten in the 15 months’ lead up to China’s coming-out ball, which is of course the Beijing Olympics”.
SCB’s Mr Green predicts that the authorities ultimately will have to take action. “Given the enormous liquidity in China, strong profit news, and small investor bullishness, the index is likely to continue upward if Beijing does not act to cool things down… If nothing happens, the Shanghai composite hitting 5,000 within one month is possible”.
“Some in Beijing see no need to interfere in “the market”, while others are increasingly uncomfortable with these valuations (average price-earnings are now 45 to 50-plus, compared to Asia’s average range of just 14-18) because they fear the consequences of an asset bubble,” he notes.
SCB has “a lot of sympathy with the view that one should let the market decide things in general, with the government playing the role of an effective umpire. But in this situation, since interest rates and the exchange rate are not set freely by the market, and the capital markets are undeveloped, there are distortions in China’s asset prices and wider macro-economy.”
The likelihood of some sort of action as the index moves up from 4,000 towards 5,000 increases significantly. “This is a real test for the State Council – they usually move gradually and by consensus on all types of policy; move slowly now and the risks of a much bigger, more painful correction later in the year increase.”
Mr Green lists possible options available to Beijing — some of which make more sense than others
- Talking the market down, possibly with an old-style People’s Daily op-ed or with speeches. This would be a first step but “it would unlikely have any effect if it is not followed up with policy”, he says. Indeed, Chinese officials have openly expressed alarm at the markets’ heady rise, with little effect, as the FT noted on Wednesday.
- Impose a capital gains tax, though the notion is “widely resisted” by institutional investors in China who term it a ‘sledgehammer’ policy. “However, using tax policy to sort out valuations is not the right tool at the right time — tax frameworks are complicated to set up, take a lot time to implement, and then are in place for the long-term,” notes Mr Green. Hmmm… so possibly not, although Jonathan Anderson, UBS‘s HK-based chief economist, noted in a report on Thursday [via Bloomberg] that the China Securities Regulatory Commission may step up efforts to cool the rally by tightening share-buying restrictions further and imposing taxes on stock-market gains.
- Encouraging one or two large-cap firms to move forward their sales of state shares to enable more equity to flow in. “This policy has the advantage of not being too interventionist in character”, notes Mr Green. But surely, we ask, that would only further fuel the frenzy?
- “There is some talk of a ‘double-interest hike’ (54bps) to calm the stock market. That would certainly cause a short-term sell-off since it would signal a change in the government’s attitude,” says Mr Green. He notes that interest rates can’t just be adjusted to sort out one market, and a double-hike would be unprecedented. One rate hike is more likely, however, and could also be justified by the strong macro-economy. SBC expects two more hike of 27bps each this year, but spread apart these would be unlikely to fundamentally change market sentiment if they are not combined with other measures.