Both A-shares and H-shares entered a bear market this week with declines in excess of 20% from their late January peak. China will blame US President Donald Trump for firing the first shots in a trade war and spooking the Chinese stock market, and rightly so: China’s stock market wobbled in direct response to announcements and leaks from the White House.
Inadvertently, Trump has done Chinese Premier Xi Jinping a gigantic favor. China’s long-overdue reduction of leverage had to put pressure on stock prices in any event, and Trump’s trade threats allow Beijing to shift the blame to the barbarian on the border rather than the imperial palace.
As the chart makes clear, the post-2007 decline in the Shanghai Composite Index followed a decline in corporate leverage, and its post-2013 recovery followed a rise in leverage (measured by the ratio of net debt to earnings before interest, taxes, depreciation and amortization). By 2016 the Shanghai Composite was levered nearly 4:1. That’s nothing to panic about: leverage in America’s small-cap Russell 2000 index reached 6:1 before falling to 4:1 in 2017. Leverage on the S&P 500 is only 1.5:1, but the ratio is skewed by a handful of cash-rich tech companies who are major net lenders. Excluding the least-levered 100 members of the S&P 500, the remaining 400 members have a leverage ratio of 3.5:1, not much different than the Shanghai Composite.
Nonetheless, the Chinese government is determined to reduce leverage, for a number of good reasons. First, leverage and the potential for nonperforming loans is concentrated in less-productive older industries that the banks have kept on life support. Second, the so-called Shadow Banking sector has funded dodgier ventures at high interest rates; although it represents a small part of the total banking system, it is large enough to be a concern.
The growth rate of shadow banking reached an alarming 45% in 2013 before falling to around zero this year. The growth rate of overall lending declined from around 16% in 2012 to about 12.6% today.
Leverage in the short-term multiplies earnings, and the stock market usually likes it. Deleveraging usually involves issuing more equity (diluting existing shareholders) to pay debt, and the stock market usually doesn’t like it.
China’s industrial profits are strong, and the Shanghai Composite is not overpriced at 11 times forward earnings. But it faced a stiff headwind due to de-levering. Now Beijing can blame it all on Trump.