The 2015 Stock Panic of China: A Narrative
Shanghai Jiao Tong University
June 14, 2016
This essay documents the boom and bust of the Chinese A-share bubble in 2014-2015. The short-lived bull market started with the expectation of the state sector reform, capital market opening-up, and monetary easing. It was then fueled and heated by the flooding of new investors and the runaway leverage. The regulatory bodies failed to check the leverage in the early stage. Forceful crackdown on leverage, which came too late, finally tipped the market toward a violent crash. The 10% daily trading limits and the voluntary suspension of trading exacerbated the illiquidity problem during the crash. To make a more robust financial system, China has to strengthen regulation and supervision of financial activities. For this purpose, China should consider re-unifying the currently segmented regulatory and supervisory bodies into a new powerful authority above the ministerial level.
The 2015 Stock Panic Of China: A Narrative – Introduction: The Case for Bull Market
Before the bull market started around July 2014, the Chinese “A-share” market was among the worst performing stock markets in the world. The rebound from the bottom of global financial crisis (GFC) was short-lived. From early August of 2009, when the U.S. stock market was still in the early stage of a persistent bull run, the A-share started a grinding bear market. On Jun 30 of 2014, the Shanghai Security Exchange Composite Index (SSECI) closed at 2048.33, not far from the year-low of 1974.38, or the post-GFC bottom of 1849.65 touched in June 2013 (Figure 1).
There were three key words behind the forthcoming bull market: Reform, Opening Up, and Monetary Easing. The 3rd Plenum of the 18th Communist Party of China (CPC) Conference declared that China would continue to reform. In particular, the state-owned-enterprises (SOE) would be encouraged to diversify ownership (mixed-economy reform) and improve corporate governance. Since the majority of the listed companies in the A-share market were of local or central government background, reform would be a tremendous boost for the market. Indeed, the SOE reform became a fascination of investors and any news of SOE reform seemed to be good news. Sinopec, for example, gained 10% (the daily higher limit) following the announcement of mixed-economy reform on Feb 19 of 2014. With reform, even big elephants could fly.
The same conference also stressed the need to reform and open up the financial system. The Chinese financial system had long been dominated by a few state-owned large banks. A vibrant stock market was obviously a blessing for the desired transition from “made in China” to a more balanced economy. Partly to bolster the ailing stock market and partly to diversify investor base, the Shanghai-Hong Kong Connect was announced in April 2014 and finally put to work in November of the same year. Before the announcement, most of the large blue chip companies in the A share market had lower valuation than their counterparts in Hong Kong Stock Exchange. (Dual-listing companies offered ample evidence.) Indeed, stocks with dividend yields over 5% were not exceptions. Following the announcement and especially the final opening-up of the Connect, the large blue chips experienced dramatic bull runs that soon wiped out the valuation gap between Shanghai and Hong Kong (Figure 2).
And finally, monetary policy started to loosen up, after years of tightening and with much evidence of economic slowdown across the country. As of Jun 30 of 2014, the required deposit reserve ratio for large banks was 20%, which was abnormally high (Figure 3). The benchmark deposit interest rate stood at 3% and the benchmark loan rate was 6%, both of which were actually much lower than the prevailing market interest rates. For example, retail savers could obtain about 5% by investing in “wealth-management products”, which were implicitly guaranteed by the banks. Wealthier savers could also enjoy around 10% by investing in “trust products”, which were implicitly guaranteed by the trust companies. If a company had to obtain financing by issuing trust products, it had to pay 15% or even more.
With monetary tightening at such scale, it is not surprising that the economy started to slow down. And in 2014, the slowdown already seemed ominous. Although the real GDP growth was kept above 7%, the official target, the nominal GDP growth fell to single digits, implying either an inflated real GDP growth or a steep disinflation (Figure 4). The growth rate in industrial value added, which was usually in the double digits, fell to single digits since the end of 2013. The generated electricity, a widely respected measure of macro performance, fell to levels only seen during past crises. The producer’s price index (PPI) fell into negative territory in early 2012 and stayed negative thereafter. Even the housing market, which had been hot for over 10 years despite stringent government measures to restrict demand, started to cool down. Given such a dire macroeconomic situation, it was all but certain that monetary policy would loosen up, or at least stop tightening.
Equally important, the pledged opening up of the financial market would make a strong case of convergence between the domestic risk-free rate and the world level, which was close to the zero bound thanks to the quantitative easing (QE) measures taken by major central banks.
So the stage was set for a bull run. The market was obviously oversold, especially the big blue chips. The talk of reform was a free option with unlimited upside. The opening up of the financial market would both bring external demand for shares and global liquidity, which was abundant. The macroeconomic slowdown necessitated a tum of monetary policy toward more accommodative of investing. The bull was ready.
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