I find it both disturbing to read reports that prominent investors and investment firms encouraging people to apply the mindless “buy on the dips” mentality to the current sell-off in the Chinese stock market. Why do I say that? Because the Chinese stock market is, as far as I can see, officially dead. It is no longer functioning as a market after Chinese authorities panicked this week and closed much of the market to trading while threatening short sellers with criminal prosecution. They have also placed a moratorium on new IPOs and prohibited selling by shareholders owning more than 5% of the shares in any company while also prohibiting large pension funds from selling shares. For all intents and purposes, China no longer has a functioning stock market although for some reason few commentators or media observers have stated this obvious fact.
Investors are encouraged by the sharp recovery in shares on Thursday, but calling it a “dead cat bounce” is overstating the case since at least half of the cat remained in suspended animation.
Why anybody would be the least bit surprised by what is happening in Chinese markets is a mystery. After falling steadily for four years, Chinese stocks finally began to catch a bid last summer. Chinese authorities saw an opportunity to shift speculation in their massive over-indebted economy from real estate to stocks and soon investors were off to the races. But the Chinese stock market is dominated by unsophisticated individual investors. More than 80% of trading is done by individuals, in sharp contrast to the institutional base of Western markets. And 67% of the people opening new accounts in China had less than a high school education. While some might argue that is an advantage in the stock market when they read some of the inane research written on Wall Street to justify the valuations of social media and biotech stocks, the truth is that the Chinese stock market had become an out-of-control casino that was headed for a fall.
Even worse, buying was supported by massive margin borrowing. Margin debt has grown to record levels in China and is among the highest in the world relative to market cap and is comparable to the levels seen in the US in the late 1920s. Many of these margin loans have started to be called in over the past few weeks as stocks have plunged, creating self-reinforcing downward pressure. There are very few foreigners in China’s markets; foreigners still mostly confine themselves to Hong Kong listed H-shares. While there has been a great deal of discussion regarding when China’s A-shares may be included in the MSCI indices, which would presumably massively increase demand for these shares and boost prices, the timing of inclusion remains uncertain and unlikely to rescue investors from the current crash.
Many commentators including Bridgewater Associates L.P. believe that the stock market downturn will have a limited impact on China’s economy. They are correct in pointing out that the stock market is not the economy even though it plays one on television. Nonetheless, a crashing stock market which is now a suspended stock market is another problem facing Chinese authorities as they try to manage a difficult economic situation. According to the McKinsey Global Institute, China’s debt has risen from $7 trillion to $28 trillion since the financial crisis. For all we know, since China’s economic data is questionable, it may be even higher. While China purports to operate under different economic rules than the rest of the world, it still has to pay its debts. And while its economy is slowing to low single digit growth (expectations of continued 7-8% growth are a pipe dream), debt continues to grow at much higher rates. The last thing China needs is for its experiment in shifting speculation from housing to stocks to implode in its face. Collapsing stocks can’t possibly help domestic consumer demand or economic growth. And a slowing China, which has already decimated global commodity prices since last summer, can only place further downward pressure on heavily indebted Western economies.
China can pretend that its stock markets are still operating normally, but investors need to acknowledge that they have been largely closed down. When short sellers are facing the equivalent of the tank staring down the lone protester in Tiananmen Square, and large stockholders are prohibited from selling while negative comments about the market are outlawed, even capitalism with a Chinese character needs to find a different name. And that means investors would be wise to steer clear.
