THE two events that shook the world in June and early July were the Greek crisis and China’s stock market gyrations.
Both events were about getting prices right – the Greek negotiations on whether Greece can sustain such high debt without some debt write-offs and the Mainland stock markets finding their own price equilibrium.
After nearly seven year’s stagnation of drifting around the 2,000 level, the Shanghai Composite rose sharply this year to 5,166 on June 12 and then went for a 30% correction, ending up with an unprecedented intervention by the authorities. The index seemed to have stabilised at the 4,000-4,200 level this week.
There was no doubt that the Shanghai and Shenzhen markets demonstrated considerable “irrational exuberance” in the run-up to 5,166, and that the expected correction turned out to be a classic crowded exit, as price drops removed market liquidity and the illiquidity forced more price drops. Margin finance played a considerable role in creating market fragility as margin stop losses and liquidation reinforced the downward spiral.
As the dust settles, it is useful to review the purpose of stock markets and how the next phase of reforms may make another intervention unnecessary. Hong Kong did a major review after the stock market intervention of 1998, resulting in a new Securities and Futures Act, the merger and demutualisation of the stock exchange and also a revamp of the financial technology infrastructure.
Stock markets basically fulfil four key functions: resource allocation, price discovery, risk management and corporate governance. The stock market does the resource allocation primarily through its initial public offering (IPO) process, whereby companies can raise capital directly from investors, who can then trade the shares on the secondary market, namely, the price discovery process.
Stock markets also fulfil a risk management and hedging function since investors can buy, sell or short (hedge) their holdings. Finally, the stock market imposes corporate governance discipline through enforcing the listed companies to disclose their activities that affect their shareholders, such as prospectuses, quarterly and annual reports.
One of the problems of the Chinese Mainland stock markets is that the IPO fund raising process has been stopped every now and then for fear that too much offerings would suck liquidity from the market and hurt prices. The result is that between 2008-2013, the stock market raised less than 3% of the total social funding of the Chinese economy, the bulk being funded by bank loans and debt. This imbalance between the capital market and the banking/debt market has meant that the Chinese economy relied mainly on debt to fund long-term investments and working capital, resulting in a rising debt-to-GDP ratio.
The risk management function of the stock market is critical to the funding of the real economy because by raising more capital/equity relative to debt, companies and the economy as a whole become more capable of absorbing sudden shocks to the system. This is because debt adds fragility to the whole system, over-borrowing being the fundamental reason for the Asian financial crisis of 1997/98, the US sub-prime crisis and the European/Greek sovereign debt crisis of 2007/2009.
One key warning signal of financial fragility is the widespread use of borrowed money to buy shares (margin financing). The latest stock exchange data showed that margin debt provided by Chinese securities houses rose from around 350-400 billion yuan when the index was 2,000 in 2013/14 to over 2 trillion yuan by May 2015, with margin-financed trading rising from less than 10% of total turnover to over 16% over the same period.
Unofficial estimates of margin finance provided by Internet finance companies and shadow banks for share trading, which are unregulated, may amount to another 2 trillion, suggesting that as much as one third of turnover could have been due to speculation using borrowed money.
This meant that when the market fell, stop losses and forced selling pushed prices down faster than would have been normal. We also cannot rule out the possibility of computerised progamme buying and selling aided a “flash-crash” scenario that added to the panic.
Most analyses of the China stock market experience focused on the US$3 trillion losses in market capitalisation when the index fell. The 2007/2008 crash, when the Shanghai index fell from 6,000 to 2,000, did not require intervention because everyone accepted the fact that the crash was due to the global financial crisis. But since retail investors were also involved in margin trading, the impact of the losses was much broader than the previous crash.
Secondary stock market trading is a zero sum game, with sellers at high prices being the winners and those who bought at high prices being the losers. If the underlying real economy has not suffered permanent damage, there is a distribution problem in terms of losers and winners in the stock market debacle.
Unfortunately many losers are retail investors, especially those who bought tech or penny stocks at high valuation without good fundamentals or corporate governance. Those who made gains are those that sold when the market was rising.
One key lesson from this incidence is that the Chinese markets have grown at speeds, scale and complexity that outran the ability of the bureaucracy to monitor its inherent risks and implications. While the market makes the final decision on resource allocation, all bureaucracies are tempted to protect it from “undue volatility”. Therein lies the contradiction between markets and the state.
Markets like Hong Kong employ market professionals to ensure that there is constant feedback between market developments and their supervisory implications. In this age of derivatives, globalisation, Internet trading and information, getting the framework right between market and state is much more complex than previously thought. This live stress test, however painful, creates a golden opportunity for the reform of the Chinese markets as they begin to converge with global markets.
- Andrew Sheng comments on global trends from an Asian angle.
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