In a clear case of be careful what you ask for, one would have thought the Chinese government would have learned its lesson the first time.
In case it wasn’t clear in June, when you take money out of the stock market, the shares prices fall. It’s a pretty simple equation, but one the Chinese government is having a hard time grasping.
After three weeks of calm in the markets, reports that China’s state-owned margin lender was returning funds early sent Chinese stocks into their worst one-day percentage loss since 2007.
The Shanghai Stock Market Composite Index plummeted 8.5% to 3,726. The Shenzhen Stock Exchange Composite Index tumbled 7.0% to 2,160, and the small-cap ChiNext Price Index sank 7.4% to 2,683. Hong Kong’s Hang Seng Index dropped 3.1% to 24,352 and the Hang Seng China Enterprises Index skidded 3.8% to 11,231.
On the mainland markets, more than 1,700 stocks fell by the daily 10% limit. This implies they would have fallen more if allowed, so people should expect more of the same tomorrow.
“After two weeks of steady rebound, both foreign investors and domestic institutions are gradually taking profits, increasing selling pressure,” Yu Jun, strategist at Bosera Asset Management told Reuters. “In addition, investor confidence hasn’t fully recovered. There has been no obvious increase in outstanding margin loans, while the amount of fresh capital inflows is much lower than the average level in May and June. With not enough money taking up the baton, a renewed, sharp correction is inevitable.”
Let’s rehash, shall we?
On June 12, the Shanghai Composite Index hit 5,166, having surged 152% over the previous 12 months, and 60% year to date. Worried that the market was in a bubble, the Chinese government tightened the rules on margin lending, which allows customers to buy shares of stock with only a small-percentage down payment.
With the easy-money spigot turned off, savvy investors realized there would be fewer people to buy their shares, so they did what savvy investors do, and sold to capture profits. This caught the unsophisticated investors by surprise, as did the margin calls they quickly received, forcing them to sell their stock to cover their loans. This vicious circle sent the Shanghai benchmark plunging 30% over the next three weeks.
Stock markets are simple mechanisms. It’s the supply and demand equation at its most foundational level. If supply stays the same, but you reduce demand, prices fall.
On July 10, Chinese news outlet Caixin said the amount of margin on the A-share market had fallen 36% over the previous three weeks to 1.46 trillion yuan, in other words, 36% less demand. As we mentioned that day, if you take that much money out of the system, a 30% drop in share values is to be expected.
So, the Chinese government got what it wanted. Of course, the government just wanted things to cool down, not turn ice cold. But, markets have minds of their own and refused to be tamed. So when prices fell investors of all stripes decided to take their profits before they completely disappeared. This kind of action feeds upon itself.
For a whole bunch of reasons, from the government tying its competence at running the economy to the stock market’s performance to top political leaders complaining about losing money in the market, Beijing was forced to prop up the stock market.
In addition to halting the trading of some shares and preventing companies and their executives from selling shares in their own companies, Beijing loosened the rules on margin. One of its key tools was the China Securities Finance Corporation (CSFC), the only institution that provides margin financing loan services to Chinese securities firms.
On Monday, Reuters reported that the CSFC has returned ahead of schedule some of the funds it borrowed from commercial banks to stabilize the stock market. The CSFC had been borrowing the money to buy stocks and was considered a prime reason the market stabilized and rebounded 16%. Investors took the returned money as a sign that Beijing’s commitment to supporting the market may be running out of steam. The CSFC did not respond to Reuter’s calls for comment.
This comes on the heels of comments from the International Monetary Fund telling China that while interventions can be useful, stock prices must eventually find their equilibrium through market forces.
So, the Chinese government again took liquidity out of the market, and again the market fell. This shouldn’t continue to be surprising.
“The lesson from China’s last equity bubble is that, once sentiment has soured, policy interventions aimed at shoring up prices have only a short-lived effect,” wrote Capital Economics analysts in a research note.
And here’s a fun fact, according to Bloomberg, when the Chinese market plunged 8.8% eight years ago the government had also cracked down on the use of borrowed money to buy stocks.
“Today’s rout in China poured cold water on investor sentiment,” Mari Oshidari, a Hong Kong-based strategist at Okasan Securities Group told Bloomberg. “This also revealed the market is still too fragile without government support.”
On, the plus side, since the start of the year Shanghai benchmark is still up 15%, the Shenzhen Composite is up 53%, and the ChiNext is up 82%.
So where does that leave us?
For months, Asia Unhedged has been saying that the People’s Bank of China needs to cut interest rates before not only a stock market shakeout, but more severe systemic disruptions. The PBOC needs to immediately cut rates one full percentage point, instead of dribbling out ineffectual 25 basis point cuts that come without rhyme or reason.
We predicted that that the apparent “success” of last week’s market support measures would delay these actions until the next market washout. Well, that washout is here. Let the rate cuts begin.