Up 150% in 12 months, down 30% in 4 weeks… sounds like a high roller in Las Vegas on a betting binge? Actually it’s the stock market belonging to the world’s largest economy – China.
With everyone is clamoring to get a piece of Chinese economic prosperity, Australia is uniquely placed to benefit. Our close geographical proximity and our resources, which China needs to build infrastructure, have contributed to Australia’s unprecedented 25 years of economic growth. Trade between China and Australia is worth $160 billion each year, meaning China is far and away our largest trading partner.
Australia has also been successful in attracting investment from China. Chinese investors have invested over $60 billion in Australia since 2003, making us, along with the US, the top place for Chinese investment. Australia’s continued prosperity is dependent on the health of the Chinese economy. And te Chinese stock market crash in recent weeks has rightly got a lot of Australian investors worried.
In April the Shanghai stock exchange grew an eye watering 150% in one year. According to the Chinese Media, this was only the beginning of an unprecedented bull run. However, the largely state-owned media could not have been more wrong. Since early June, Chinese stock markets have declined 30% resulting in losses in the order of 3.9 trillion dollars.
Yes – $3.9 Trillion – twice the size of Australia’s annual GDP, 16x the Greek economy.
Margin lending has become increasingly popular in China in recent years as investors sought to make the most out of the then booming market. Margin lending works by allowing investors to borrow money against their shares, enabling a greater investment in that stock or other securities. This type of leverage increases investors’ profits when the market goes up, as the investor has a greater exposure than they would normally have.
However, this can work in reverse when markets fall, as investors’ losses are also magnified. Not only does the investor have a greater propensity for loss, but whoever has leant them the extra money against the security of a share will “cut their losses” and force a margin call. In a margin call, the investor either needs to put in the extra cash needed to bring their account back to an appropriate position, or their shares are sold by the lender. It’s the latter that can put markets into a death spiral if a great deal of investment is based on borrowed money.
China’s official banking system is highly regulated and getting access to finance is difficult and often expensive. As a result, a shadow banking system developed, opening access to easy finance to its billion plus population.
While the Government is trying to stamp out these practices, shadow banking in China is responsible for trillions of dollars of margin lending. The exact figure is hard to quantify because shadow banking is often done through complex subsidiary arrangements which make it hard to monitor what is actually going on.
The sharp decline of the Chinese stock market is being exacerbated by margin calls as lenders call in loans. Privately owned steel mills have been liquidating iron ore inventory, so owners could cover margin calls, causing the iron ore price to fall a massive 10% in one session.
The crisis has also brought into clear focus the role that shadow banking has in the Chinese economy, prompting calls for more supervision to prevent unsafe practices.
The Government has begun implementing measures to start regulating the shadow industry. However putting pressure on the shadow banking system means that investors are having a hard time accessing finance, causing the stock market to plummet further.
It has taken drastic steps to intervene to stop the slide by:
Did these measures work? Yes, the market closed 5% higher for the week. But the real question is whether this is sustainable. Dual listed shares in the Hong Kong market are trading 33% cheaper… suggesting foreign investors aren’t buying the valuations.
China needs long-term reform and measures that ensure the economy performs in an competitive and efficient way over the long haul. Short term interventions of the ilk we have seen are likely to create a different bubble, which will be too big to manage.
