China's stock market boom and bust

Ask a well-educated person which country boasts the largest equity market and you’ll usually get the right answer: the United States. Ask which country has the second largest market and you’re likely to get a range of answers: Japan? Britain? Germany?

The answer is China. In terms of annual trading volume, China’s equity market has been #2 since 2009. Measured by total market capitalization, it has been #2 for seven of the past nine years. As of May 2015, the market capitalization of domestic issues on the booming Shanghai (SSE) and Shenzhen (SZE) exchanges combined surpassed US$10 trillion – when you add in Hong Kong, it was over $14 trillion. That’s more than double the capitalization of the #3 market – the Tokyo exchange – and second only to the $27 trillion combined capitalization of the New York Stock Exchange (NYSE) and NASDAQ OMX markets (see charts below).

Why should this matter now? First, because it highlights the extraordinary spread of market-based finance in a country led for more than 65 years by its communist party. Vladimir Lenin once spoke of controlling an economy from the “commanding heights” at its center. In contrast, a stock market decentralizes economic decisions by allowing millions of investors to determine the valuation of firms, thereby improving the allocation of capital. According to one report, there are now more individual brokerage accounts (90 million) for trading of domestic stocks in China than there are members of the communist party (88 million).

Second, because the growth in Chinese equity markets comes with sizable risks. Recent experience drives home this point. In the year to June 12, when stock prices peaked, valuations on China’s domestic exchanges skyrocketed, rising by more than 150%. However, in the past few weeks, prices have plunged, wiping out about $2 trillion of market capitalization. Nevertheless, equity valuations remain at roughly double the year-ago level. All of this extraordinary volatility has occurred despite intensifying efforts by Chinese policymakers to stabilize the market.

Top Stock Exchanges (ranked by market capitalization in trillions of U.S. dollars, May 2015)

Source: World Federation of Exchanges and (for LSE) London Stock Exchange.

Source: World Federation of Exchanges and (for LSE) London Stock Exchange.

Domestic Stock Market Capitalization (Trillions of U.S. Dollars), 2003-July 6, 2015

Source: World Federation of Exchanges through May 2015 and authors’ estimates for latest observation.

Source: World Federation of Exchanges through May 2015 and authors’ estimates for latest observation.

What was behind China’s stock market surge? We see both internal and external influences. Inside of China, a series of fundamental factors made alternative investments less appealing. There are the recent financial reforms, especially government efforts to limit the implicit guarantee for the country’s shadow banks. There is the ongoing decline in residential real estate values that has diminished the competition for scarce savings from housing investment. And then there is the monetary stimulus in the form of lower interest rates. All of these push equity prices up.

Externally, foreign investors are increasingly interested. The low correlation of the Chinese equity market with other countries’ stock markets makes it an attractive diversification opportunity. While nonresident access to China’s “A” shares remains limited, activity has been rising, partly as a result of the new Shanghai-Hong Kong Stock Connect system that lowers the cost of cross-border transactions.

More important, both resident and nonresident investors may be anticipating the inclusion of A-shares in the leading global equity indexes, like the FTSE and MSCI. MSCI, for example, is engaged in active discussions with China’s securities regulators regarding the quota allocation process, continued restrictions on cross-border flows, and legal ownership issues. Upon resolution of these issues, MSCI expects to add A-shares to its indexes. This will prompt asset managers (especially those with passive index tracking funds) to include these equities in their global and emerging market portfolios, almost surely leading to a large volume of foreign purchases. [Consider that the combined market capitalization of the Shanghai and Shenzhen exchanges is now roughly double that of the current MSCI emerging markets basket of $4 trillion: while this surely overstates China’s likely future weight in the index, it highlights the large potential increase in demand for shares.]

Yet, not all the news has been so favorable. First, China’s economy slowed markedly over the past year, beyond what some informed observers anticipated. Second, consumer price inflation has dropped well below the government’s 2015 target of around 3%. Third, government moves to relax the cap on bank deposit rates will tend to increase the return on a perceived safe alternative for households. [There is now talk of scrapping that cap altogether, making bank deposits even more attractive.]

Perhaps most important, the surge in stock prices boosted price-earnings (P/E) ratios to levels we consider hard to justify. At the June 12 peak, the P/E ratio on the Shenzhen exchange – which includes more speculative listings – temporarily exceeded 70. Since then, equity prices have plunged, but the average Shenzhen P/E remains at a still lofty 45. Less troubling, the average Shanghai P/E has dropped to about 18, somewhat below the U.S. S&P 500 (21.3) and the Nasdaq 100 (22.6). Another sign of vulnerability is the premium of A share prices relative to shares of the same firms that trade in Hong Kong (“H” shares): based on one popular index, that premium has fluctuated between 20 and 40 percent this year, notably above the range that has remained close to zero in recent years.

Most disturbing, it appears that China’s equity market has attracted a large number of uninformed traders at the same time that stock purchases have depended increasingly on leverage. The next chart highlights these developments. First, the number of new brokerage accounts created in the first five months of 2015 – nearly 18 million – exceeds the total created over the previous four years. It is doubtful that so many new investors understand the risks in the market or the fundamental factors like the risk-free interest rate and the prospective growth of dividends that underpin equity prices in the long run. Rather, it is at least plausible that the wave of retail interest in equities reflects at least in part the market’s price momentum, consistent with the “noise trader approach to finance.” In theory, more knowledgeable skeptics could counter the wave of uninformed retail buying by selling a financial futures index of Chinese equities like the large-cap CSI300 (which recently became the world’s most actively traded equity futures contract!), but doing so is hardly free of risk.

The increase in the number of investors has been accompanied by a surge in margin credit. From May 2014 to May 2015, margin credit rose from RMB 0.4 trillion (3.1% of tradable Shanghai market capitalization) to RMB 2.1 trillion (6.7% of market cap). Brokers provide margin loans to customers who wish to increase their equity (or other) exposure beyond what their own savings and other investments permit. However, because these loans are typically collateralized by the customer’s holdings, brokers usually have the authority to seize and sell the collateral when falling asset prices put the loan repayment at risk. Such fire sales can amplify the equity bust, just as purchases on credit amplified the boom.

Margin credit (share of Shanghai stock exchange tradable market capitalization) and new shareholder accounts (millions), 2007-May 2015

Sources: Bloomberg and Shanghai Stock Exchange monthly reports.

Sources: Bloomberg and Shanghai Stock Exchange monthly reports.

This configuration of skyrocketing prices, a large increase in the number of investors, and a burst in margin credit leads us to compare China today with the stock frenzy in the United States in the late 1920s. At the start of 1927, brokers’ loans (which brokers typically received from banks to satisfy the margin needs of their stock-trading customers) already stood at 8.6% of the total value of listed NYSE stocks (see chart below). Just before the October 1929 crash, they reached 9.5% of the total. Then came the fire sale: over the final three months of 1929, brokers’ loans halved while the equity market fell about 30%.

Market value of NYSE listed stocks (U.S. dollars in billions) and brokers' loans (as a share of market value), 1927-34

Sources: Brokers' loans from Federal Reserve Banking and Monetary Statistics 1914-41, Figure 139, page 494; NYSE market value from Barrie A. Wigmore, The Crash and its Aftermath: A History of Securities Markets in the United States, 1929-1933, 1985, Table A.22.

Sources: Brokers' loans from Federal Reserve Banking and Monetary Statistics 1914-41, Figure 139, page 494; NYSE market value from Barrie A. Wigmore, The Crash and its Aftermath: A History of Securities Markets in the United States, 1929-1933, 1985, Table A.22.

Against this background, the recent dive in the Chinese stock market seems unsurprising. As we know from experience, equity markets are inherently volatile (consider the 57% peak-to-trough drop of the S&P 500 from October 2007 to March 2009).

But, we also know that, at least in stock markets that survive over the long run, equities typically provide outsized returns to compensate for that risk (see here for models of the “equity risk premium”). And, despite their extraordinary volatility over the past year, there is growing evidence that China’s equity markets are more than just a casino. According to one recent study, the market “has become as informative about future corporate profits” as the U.S. stock market. Moreover, this change has been correlated over time with an improvement in Chinese firms’ investment efficiency, suggesting that the market is “generating useful signals for managers.”

So, what’s the bottom line? In the short run, if a bubble is driven by uninformed investors buying on credit, watch out for a further fire sale of China’s A shares, despite the widening efforts by policymakers to stabilize the market (including restraints on short sales, relaxation of margin lending rules, suspension of new stock issues, and promotion of market stabilization funds).

In the long run, China’s big equity market presents an excellent alternative to bank loans as a means of financing corporate investment. A thriving equity market, driven by profits rather than politics, will almost surely improve the efficiency of capital allocation compared to decisions made from the “commanding heights.” And, as cross-border flows further liberalize, China’s equity market will provide savers around the world with a chance to invest in the country that still contributes more to global economic growth than any other. But free and transparent equity markets are unavoidably volatile. And that volatility is likely to be exceptionally high in an economy that is transforming as rapidly as China’s.

Overall, we are convinced that the good far outweighs the bad (so long as you're not borrowing to invest today!).