After putting up with a bear market for years, the Chinese stock market started to rally last autumn against the backdrop of a new easing cycle by the People’s Bank of China (PBoC). As if this were not enough in a largely liquidity driven market, the PBoC promoted stock market financing by easing margin credit conditions. As a result, the Shanghai stock market skyrocketed for about nine months until it suddenly moved into red to end up with a huge sell-off, which has wiped out one third of China’s stock market value.
The key questions I will address in this note are why all of this is happening and why we should care.
Why Did We Have a Bull Market to Start With?
The stock market rally was clearly sponsored by the Chinese government. It all started with the widely trumpeted announcement of the Shanghai – Hong Kong Stock Connect last year to help Chinese corporates raise equity beyond the Mainland, with the announcement of a huge number of IPOs following suite. The underlying reason for the Chinese to push the stock market at that time was that Chinese banks and corporations needed a venue to raise equity after an era of excessive leveraging. Yet neither the Shanghai nor the Hong Kong stock market was well placed after years in a bear market.
The need for Chinese corporations and banks to avail themselves of fresh equity cannot be underestimated. On the one hand, corporate debt has grown sixfold from 2005 levels. On the other hand, Chinese banks are not only heavily exposed to these corporates, being still their main source of financing, but also to local governments whose huge borrowing from banks is starting to be restructured. To make a long story short, China’s governments needed a bull stock market to transfer part of the cost of cleaning up its corporates’ and banks’ balance sheets from the state to private investors, including foreigners. The PBoC danced to the Government’s tune, easing monetary policy since November last year. This was done through several interest rate cuts and by lowering the liquidity ratio requirements. The problem with all of this liquidity is that it only fueled additional leveraging, including for gambling on the stock market. The demand for stocks was abundant for two main reasons: the real estate market was no longer a venue for quick gains and shadow banking is less accessible than before – not to talk about the even lower interest rates offered on bank deposits after monetary easing.
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