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Has Market Turmoil Shaken China’s Commitment to Reform?

Investors struggle to assess where real value lies in mainland stocks and whether Beijing remains committed to financial reforms.

Last month, On his inaugural visit to the U.S. as China’s president, Xi Jinping stopped in Seattle to meet with the cream of the U.S. technology sector, including the CEOs of Amazon, Apple, Facebook and Microsoft Corp., and to promote his country’s tech champions, such as Alibaba Group Holding and Baidu. So it was something of a surprise that when he addressed a banquet of business and political leaders during his Pacific Northwest visit, he made a point of defending Beijing’s controversial stock market rescue.

“This time the Chinese government took steps to stabilize the market and contain panic in the stock market, and thus avoided a systemic risk,” Xi told the audience. “Mature markets in various countries have tried similar approaches. Now China’s stock markets have reached the phase of soft recovery and self-adjustment.”

It was the first time a top Chinese leader had commented publicly on the massive stock market rescue. Analysts estimate the government has spent 1.5 trillion yuan ($235 billion) to support the stock market after a dramatic collapse that saw the Shanghai Stock Exchange Composite Index plunge by 43 percent between early June and late August, and wiped more than $5 trillion — equivalent to 50 percent of China’s gross domestic product — off equity valuations.

Although many analysts have cited China’s decelerating economy as the reason for the sharp market setback, experts believe Beijing shoulders at least as much, if not more, of the blame.

Late last year officials began talking up the stock market and encouraging government-linked funds to buy aggressively. Hype about the government’s financial liberalization agenda — including reforms ranging from the legalization of hedge funds to futures contracts for rare-earth metals to greater access for foreign investors — helped stir retail investors into action. The market responded, rising by more than 80 percent between the start of September 2014 and the June peak.

That bull run pushed valuations beyond realistic levels at a time when the economy was showing clear signs of slowing, setting the stage for a correction. At first, the authorities were content to let stocks find their own level, but when the sell-off intensified they began intervening in July with a variety of ad hoc measures. Their blunt actions stopped the rout but left many wondering whether financial reform was a casualty. “After the crash the State Council and the regulators panicked,” says Willy Lam, an adjunct professor at the Chinese University of Hong Kong’s Center for China Studies and a former senior editor at Hong Kong’s South China Morning Post. “We may see an end of financial innovation for the foreseeable future.”

A major ingredient in the rocket fuel that helped drive markets sky-high was margin trading and derivatives contracts that allow investors to borrow shares from brokers to short stocks. Margin trading and shorting began as an experiment back in 2010, but the program really exploded last year. “There is no question that valuations were stretched and licensed leverage levels had grown significantly,” says Paul Schulte, CEO of Schulte Research International, a Hong Kong–based independent research house. In addition to 2.3 trillion yuan of authorized margin loans from brokerages, analysts estimate that unlicensed curb lenders extended as much as 1 trillion yuan in credit. The government stepped in to curb margin lending in June, but Schulte says the damage had already been done. “They should have cut off the excess leverage in April and not waited until June,” he says. Regulators were late to realize the extent of margin lending and the impact of margin calls. “So margin calls would be triggered on small changes in prices,” Schulte notes. “This was guaranteed to blow up and was irresponsible on the part of buyers and sellers of this leverage.”

Authorized margin lending had fallen to 608 billion yuan as of September 2, according to China’s Shanghai Wind Information Co., a private data vendor that offers China’s version of the Bloomberg terminal. Going forward, regulators will continue to exercise stricter supervision over market leverage, analysts say.

The stock market collapse has been an expensive one for China’s 90 million retail investors, and for the government. In addition to organizing massive stock buying by state-owned banks and brokerages, the government instituted emergency measures including temporary bans on share sales by majority shareholders of listed companies, the temporary halting of trading in more than a third of the nearly 3,000 companies listed on the Shanghai and Shenzhen exchanges, and a suspension of initial public offerings. Authorities took into custody dozens of executives of major brokerages and fund management firms, a journalist and even the China chair of Man Group, a London-based hedge fund firm, as part of their investigations into “malicious short-selling.” No one has yet been prosecuted, and the authorities later released Man chair Li Yifei.

The measures have caused considerable confusion and drawn mixed reviews in the market. “So far, the mainland regulatory authorities have introduced many measures that stopped the sharp plunge in the short term,” says Tony Sheen Ching-jing, chairman of Taiwan-based conglomerate Core Pacific Group and its Hong Kong–based brokerage unit, Core Pacific-Yamaichi (International). But for the long run, he adds, “how effective they are remains to be seen.”

At a September 5 meeting in Turkey of the Group of 20 finance ministers and central bank governors, the chief of the People’s Bank of China sought to ease anxieties about the meltdown, which sent shock waves through global equity markets. Central banker Zhou Xiao­chuan acknowledged that there had been a “bursting” of the mainland stock market bubble, but he asserted that volatility was ebbing. “To some extent, the leverage in the market has been decreased substantially, and we think there would be no systemic risk,” he said.

With the Shanghai Composite just above 3,100 in late September and the Shenzhen Stock Exchange Component Index just above 10,000, the mainland’s A shares were trading at about 15.5 times earnings. That was down from a multiple of about 30 at the market peak in June but up from 11.4 a year ago.

“In our view, both A- and H-share markets are no longer expensive,” says Lu Wenjie, a Shanghai-based strategist with UBS. But Shenzhen’s ChiNext board of 464 small and medium-size enterprises was trading at 75 times earnings on September 24, down from a peak of 146 in early June but up from 69 a year ago. That multiple still needs to fall to hit a sustainable valuation, Lu says.

THE RECENT MARKET interventions stand in stark contrast to Beijing’s stance during the last big correction. In the 12 months ended in October 2008, the CSI 300 Index of leading Shanghai and Shenzhen shares plunged by 70 percent, but regulators led by central banker Zhou, a leading advocate of financial reform and a greater reliance on market forces, adopted a hands-off approach.

The passivity of regulators began to change under Xi, who assumed office as general secretary of the Communist Party in November 2012 and as president of China in March 2013. He launched far-reaching reforms, including an attack on official corruption, and consolidated power by personally taking charge of not only the military, national security and foreign affairs but also the economy.

In June 2014 he assumed control of the Central Leading Group for Financial and Economic Affairs, a powerful body under the Party’s Central Committee that sets policies for the government. In the past the group was led by the premier, but now Premier Li Keqiang serves as merely one of two deputy directors.

With growth slowing and local governments saddled with nearly 15 trillion yuan of debt, Xi wanted to channel more of the nation’s 54 trillion yuan in household financial assets toward new engines of growth, chief among them the stock market, says professor Lam, author of the recent book Chinese Politics in the Era of Xi Jinping. On April 21, for example, a commentary in the official People’s Daily declared that the “bull market has just begun.” The stock market at that point had soared about 80 percent over the previous six months, even as China’s growth rate had slowed to a six-year low of 7 percent in the first quarter. The commentary defended high equity valuations, saying the markets had “support from China’s grand development strategy and economic reforms.” Lam says, “Many investors quite logically believed that the markets could only go up.”

The bull market also drew support from the rise of peer-to-peer lending platforms. This new credit source has taken off over the past two years, with more than 2,000 P2P platforms now operating, according to a recent report by Credit Suisse. They offer retail depositors interest rates as high as 11 percent and then lend the money to commercial borrowers and stock speculators at rates as high as 60 percent.

Many of these P2P vehicles are linked to major online trading systems, including the order management system run by Hundsun Technologies, a business partly controlled by the private investment company of Alibaba founder Jack Ma. On July 13 investigators from the China Securities Regulatory Commission visited Hundsun’s offices; three days later the company announced it had stopped opening new accounts and banned existing accounts from sending new orders over its system. In August, Xi moved to take control of the government’s handling of the market collapse by shifting the job of crisis management from Premier Li to Xi’s longtime aide, Liu He. “There are divisions within the leadership,” notes Lam, who says Xi was not happy with Li’s handling of the crisis.

“It’s difficult to specify the causality of this crash, but it’s a fair comment to say there is so much happening in China that any regulator would have a hard time dealing with it,” says Michael Karbouris, Nasdaq’s Hong Kong–based head of business development for Asia-Pacific. Financial reform has taken place at a dizzying pace. Just since 2012 regulators have given the green light to the launch of stock market index futures, credit default swaps, margin trading, shorting, hedge funds, commodity-linked futures contracts and funds that invest in those contracts, and over-the-counter derivatives. Regulators also began allowing Chinese pension funds and insurance companies to begin investing in equities.

That represents a massive amount of change for a country that only legalized stock markets in the early 1990s. Kenneth Courtis, a former vice chairman of Goldman Sachs Group in Asia who now chairs his own private investment vehicle, Starfort Holdings, recalls that 20 years ago traders needed to make an appointment with an exchange official to place a trade. “So China has come a very long way in a very short time, probably faster than the regulators were prepared for,” Courtis says.

The leadership has been pursuing financial reform and opening China’s markets to foreign investors as part of its strategy to transform the economy from an export-oriented powerhouse to one driven by consumer demand. Will the stock market collapse cause Beijing to change course?

In the short term the authorities appear to want to restrain market forces. On September 8 the Shanghai and Shenzhen exchanges announced they would adopt circuit breakers to prevent panic selling. Under the plan both exchanges will halt trading for 30 minutes when the CSI 300, which tracks shares of the 300 biggest mainland-listed companies, jumps or slumps by 5 percent in intraday trading. They will stop for the day if the index moves by 7 percent.

Anshuman Jaswal, a New York–based senior analyst in the securities and investments group at financial information technology consulting firm Celent, regards the stock market turmoil as a temporary setback. “In today’s day and age, stopping reforms altogether is not a likely and practical option,” he says. “China has been liberalizing and reforming its economy for almost four decades now. This has largely been seen as a tremendous success within China and abroad.”

The impact of the market drop on the real economy is also likely to be minimal, says Wang Tao, China economist at UBS in Hong Kong. She believes the risk of a so-called hard landing is small and predicts that growth will slow from about 7 percent this year to 6.5 percent in 2016.

Still, global fund managers have turned sour on China, and it will take some time for them to return to the Chinese equity markets, says Bruno Taillardat, an equities portfolio manager at Unigestion. The Geneva-based firm has $300 million of its $17.9 billion in assets invested in China equities. “While its valuation is at a historical low level, we believe China will have to show some growth stabilization before international investors invest there again,” Taillardat says. •

Follow Allen Cheng on Twitter at @acheng87.

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