Walking the tightrope between reform and stimulus...
– The recent correction in Chinese equity markets, undoing 35% of the prior 160% rally in domestic Ashare market performance was a healthy outcome. Without it, the market was susceptible to sraightline extrapolating inertia that could have left it severely overvalued. PEs are now back in line with historic averages.
– To arrest the losses and break a potentially self-fulfilling downward spiral in prices, the Chinese authorities were decisive in in their actions, offering monetary stimulus and intervening more directly in equity markets. But herein lays its dilemma: too much interference will not bode well with international institutions and investors. However, not enough support could drive further outflows from domestic retail investors, the key stakeholders in domestic equities at the moment. The authorities will clearly have to walk a tightrope between stimulus and its reform agenda.
– We believe that China could benefit from further internationalisation. The opening of its equity market to foreign institutional investors could help embed the corporate and market discipline that other globally-exposed markets are used to. To that end we believe that China should remain committed to reform and withdraw some of the support measures that directly clash with its goals of liberalisation.
This week’s sharp decline in prices after three weeks of gains demonstrates that the market is reliant on support measures, and so cannot be removed too quickly. However, a clearly communicated path for reform and support-withdrawal will demonstrate to potential international investors that the Chinese equity markets are not as inward looking as commonly perceived.
Desperate or decisive?
Chinese domestic equity markets are in the process of correction. The Chinese authorities have responded with a heavy hand. Although prices had seemed to have stabilised with three weeks of steady gains, this week they have begun to fall sharply once more. Understanding China’s policy reaction function, we expect more intervention to come. But will the authorities’ actions help restore confidence in the financial system or do they smack of desperation? We believe that the decisive action and speedy delivery were necessary to stop the equity market from overreacting in a self-fulfilling manner. Too often markets suffer from excessive price declines. An initial price decline can trigger stops which in turn cause further price declines, triggering more stops and so on. Circuit breakers to stop this cascading downward spiral are a valuable design feature of an equity market.
At the peak, more than half of the domestically traded stocks in China suspended trading. That gave time for the dust to settle and people to realise that nothing has fundamentally changed in China. Clearly a rush for the exit was not necessary if others were not heading in that direction. Limit-down trading suspensions – the circuit breaker – are common in most equity markets. In ddition to limit-downs, some stocks halted trading at the request of the management companies. But this was nothing to do with crisis management government policies.
The government also intervened in a number of other ways including interest rate cuts, cuts to the reserve requirement ratio, relaxing rules on margin financing, suspending IPOs, strengthening the capital of the China Securities Financial Corporation (CSFC) and allowing it to purchase blue chip stocks, buying ETFs (though the governments investment fund) and strong-arming securities firms into buying blue-chips. In addition an investigation into malicious trading also has been launched. And the list goes on. Some have argued that throwing everything at the problem smacks of desperation. Conversely we believe decisive crisis management like the role-out of quantitative easing by the Federal Reserve at the heart of the financial crisis rather than the indecisive process of dealing with Greece’s indebtedness in Europe is a blueprint to follow. To do more today will avoid the problem dragging on. That is important for China given it ambitious reform agenda that should not get derailed.
But the fact that some of China’s crisis dealing measures run counter to the financial market strengthening and liberalisation reforms could be a cause for worry if they are not reversed.
The very strong rally in the equity market between November 2014 and June 2015 was facilitated by retail investors’ access to leverage. That left the system vulnerable to shocks. Tightening of margin lending was a welcome step toward strengthening the institutional framework in China. The subsequent loosening of margin lending rules (and active encouragement by the government via brokers) in the wake of the sharp price correction is understandable as a crisis measurement tool but we believe it must be reversed. The system should not become dependent on leverage, especially from the retail sector, where investors are the least able to manage the risk.
Timing the withdrawal of support measures is key. The sharp decline in equity prices this week were driven by rumors that the IMF had asked for the removal of the support measures. The fact that primarily domestic investors are spooked by the prospect, indicates that it is too soon.
Having a credible plan to get back on the reform agenda is important. MSCI decided not to include China A-Shares into it coveted MSCI Emerging Markets index in June, but has left the door open for inclusion sometime this year. China does not need to wait until MSCI’s June 2016 review as long as it allays the concerns MSCI expressed last month. The concerns surrounded ease of access to quotas (especially in light of the need for investors to replicate the benchmark), capital mobility restrictions that could interfere with liquidity, and clarity on beneficial ownership (i.e. who has title to the stocks when transacted via fund managers?).
Should there be any dragging of feet to get the reforms in place we think the ‘MSCI inclusion’ premium will dissipate further. The Chinese authorities recognize that external, institutional investors will help its equity market mature and drive the market discipline that developed markets enjoy. Keeping crisis management measures in place for too long to appease domestic investors will clearly be counterproductive.
Just as the authorities have recognised that it is the quality and not the scale of economic growth that matters, we believe the authorities will strive to strengthen the institutional framework to help generate consistent equity market gains and reduce undue volatility that has characterised the market recently.
Reform commitment: currency trading band to widen
Despite all the noise around the equity market, we believe that China is committed to reform. Over the past weekend, China announced that it will introduce more flexibility to its exchange rate, allowing the currency trading band to widen to 3% against the US dollar from 2% currently. A definitive date has not been announced, but it is clear that the country has its sight set on having its currency included in the International Monetary Fund’s Special Drawing Rights Basket (see Renminbi: The World’s Next Reserve Currency?, May 2015). China is doing all it can to demonstrate its commitment to further reform and we expect further announcements of currency liberalisation.
China hoarding more gold
China’s gold holdings have been updated for the first time since 2009, and the figures indicate that stockpiles are up by 57% over that timeframe. Since 2009, China has added 604 tonnes to its original total of 1054 tonnes. While China is now the world’s fifth largest sovereign gold holder (surpassing Russia), gold represents under 2% of its foreign exchange reserves.
As far as announcements go, China’s report of increased gold holdings was greeted with a lack of enthusiasm. Since the reporting of China’s new holdings, the gold price has declined .2%. Despite the gold disclosure, the market was underwhelmed given some in the market expecting significantly greater amounts. The 1658 tonne holdings are a far cry from the 3,500 tonnes estimated by Bloomberg Intelligence or the alleged 10,000 tonnes indicated by the China Gold Association (we suspect that this latter figure could include reserves of gold ‘held by the people’).
Nonetheless, we feel that China’s announcement is reasonably positive for the gold market, with authorities expecting to continue to accumulate. Indeed, gold holdings remain at very low levels as a percentage of reserves compared to developed countries and the PBoC has indicated that it doesn’t want to distort the market with overly large purchases. The gold buying indicates that diversification, albeit gradual, away from US dollar, continues to be a policy pursued by the government.
Speculation is rife over the ‘why now’ announcement. We expect that the move was twofold: firstly to increase transparency ahead of the IMF meeting over the Renminbi being included in the SDR
basket (see Renminbi: The World’s Next Reserve Currency?, May 2015), and secondly to help calm equity market volatility by reassuring investors that the Government has a sufficient and diversified resource base in times of need. Additionally, it highlights a steady move toward greater transparency, which is an improvement after six years of being tight lipped about its official gold holdings.
Residential building sales growth has been positive for the past 3 months, with June figures coming in at 38.9% year-on-year. The 70 city residential property rice index is still negative year-on-year, but it appears a bottom has been reached.
First-tier cities are leading the trend, having seen their house prices increase 3.0% in June. Second and third-tier cities remain in negative territory. Over-building was more of a problem in these cities and we expect that dealing with the overhang there will take come more time. However, we don’t expect the price declines to accelerate in these cities.
However, it is clear that a significantly larger number of cities are posting positive month-on-month price increases. 42 out of 70 cities posted price increases in June, up from just 12 in March.
For the recovery to last we need to see that supply remains tight i.e. building activity should remain restrained. Recent stimulus including the CNY124.3bn to be spend on affordable housing (announced in May 2015) and the State Council’s commitment to renovate 18 million units of shanty-town and 10.6 million units of rural dilapidated building between 2015 and 2017 (announced June 2015) should not add too much to the supply of housing and is targeted to a specific segment of the population.
We believe that the rout in the equity market and large scale of stimulus that has come as a result could divert retail money back into the property market. We doubt the volumes will be very large given that recent property market downturn is still vivid in the memory of many retail investors.