Following a 13.3% correction in the Shanghai Stock Exchange Composite Index (SSE) this week, the largest weekly decline since 2008, headlines across major dailies now post phrases such as “drop amid fears of equity bubble” and “China sell-off intensifies”. The market sentiment has taken an almost 180 degree change from early June where the chatter was centred on SSE achieving 7-year highs and on track to chart new historical peaks.
While Part I of my article discussed about some of the key reasons that fuelled the rally in Chinese equities – expectations of easing, liquidity boost from government policies, asset rotation and margin-lending expansion are but some of the drivers. It is common knowledge that a euphoric market sentiment is one that should not be undermined.
The discussion on whether we are headed for an equity bubble bust or the correction in Chinese equities being a near-term phenomenon continues as we move on to analyse some of the pros and cons of a robust Chinese equity market.
Pros:
Occurrence of financial reform – As Chinese equity market is dominated by on-shore retail investors, asset rotation by means of channelling more household savings into equities helps reduce overall reliance of corporate funding on banks and shifts the burden onto the equity market.
Economic rebalancing towards consumption-led growth – The Chinese government has repeatedly signalled their intention to achieving a GDP growth of at least 7%, led by consumption. Driven by technology innovation and domestic consumption, the rally in the Chinese markets has certainly created wealth for most investors to fuel consumption.
Improving valuations facilitate corporate financing opportunities – Corporate debt to equity should decline going forward, reducing the economy’s reliance on debt financing and inherently lowers overall economic risk. The improving or rich valuations of companies will be prime for a series of corporate financing opportunities such as IPOs, secondary placements.
Encourage M&A opportunities to enjoy PE arbitrage – The comparatively higher PE multiple enjoyed by Chinese companies may be an advantageous weapon for them to carry out inorganic growth opportunities through M&A with a target on companies trading at much lower valuations and earnings accretive. This is opportunistic for companies seeking to expand vertically or horizontally across the supply chain.
Lower cost of funding – Particularly for the private sector, equity financing becomes a viable channel of financing as cost of funding becomes relatively cheaper. This helps ease the financial constraints experienced largely by small and medium-sized private companies.
Capital market liberalisation - The launch of the Shanghai-Hong Kong Stock Connect is the first mutual market access initiative adopted by the Chinese government. While this has been instrumental in driving inflow of foreign funds into the Chinese equities, more importantly it is a step forward for China to move up the capital market value chain of becoming an international equity platform.
Cons
Potential equity bubble – Given that a large part of the rally in Chinese equities is driven by margin financing, which now stands at a towering US$350 billion, there is an underlying risk of defaults built by expectations and hype.
Contagion effect of rising margin debt to hurt banking system – While the margin debt of China seems manageable presently; it remains a risk as it links the banking system to stock market volatility. In order to fund loans to retail investors, brokers borrowed in the interbank market. As such, volatility in the market may cause defaults to occur and cause a chain reaction as the system is now more exposed to the brokerage industry.
Diversion of capital to equity market speculation – Although a somewhat less prevalent trend, there is observation that Chinese companies are diverting capital into the speculative equity market to generate quick and attractive returns. As these companies struggle with profitability from their core businesses in a slowing economy, this has been a strategy adopted by some. As a result, corporate profits become largely dependent on the equity market’s movement, hence affecting the volatility of earnings. In the event of a market reversal and a sluggish economy, earnings may suffer a double-blow.
Until more tangible consequences are experienced, the debate lingers about whether we are at the brink of an equity bubble bust or are we on the way to scale new highs. With no lack of positive takeaways from a robust market, it leaves little incentives for the market to head otherwise and this may be seen by Chinese regulators working their means to keep the outlined risks under control. The primary agenda for a bullish equity market remains that it will help facilitate structural reforms and revive the private sector to creating sustainable growth for China.
