Global investors have been fixated on the Greek debt drama in recent weeks, and rightly so, but another drama is heightening on the other side of the world. China’s stock market is crashing.
The meltdown in Chinese stocks presents both risk of contagion for global stocks, including our markets, and a great buying opportunity in the making for global-oriented investors.
China’s mainland Shanghai Index soared 150% higher in just 12 months through mid-June. These eye-popping gains were fueled in large part by a massive expansion in margin lending, most of it off-the-books.
A few weeks ago, officials in Beijing believed stocks could be getting overheated and decided to crack down on margin trading. Since then, Shanghai shares have plunged about 30% and have been down 13 straight days. The China stock market meltdown has accelerated in spite of Beijing reversing course and pulling out all the stops this week in an attempt to support share prices.
To better understand the magnitude of the price swings in China, just take a closer look at the magnitude of money at work.
Official margin lending in China rose to a record 2.3 trillion yuan ($350 billion) as of mid-June. Margin debt is up 123% year to date, and has grown five-fold in the past 12 months alone. But the official data is just the tip of the iceberg.
The Chinese are an enterprising people, with a thriving shadow banking business including off-the-books margin lending where brokerage accounts can be leveraged up 5-to-1 or more.
Add in the shadow margin lending to the official numbers, and Chinese mainland stocks bought with borrowed funds account for 8.5% of China’s entire free-float market capitalization, according to global investment firm Macquarie Capital — higher than any historical example the firm could find. By contrast, margin lending accounts for only 2% of U.S. stock market value.
On Saturday, June 13, the China Securities Regulatory Commission (CSRC) cracked down, issuing rules forbidding shadow margin lending. Sure enough, Chinese stocks began tumbling Monday, June 15, and continue to plunge.
With Shanghai shares still falling last week, Beijing decided to reverse field, directing the CSRC to “uphold market stability” by providing liquidity to the market, banning IPOs and restricting short selling.
Regulators also announced a 120 billion yuan investment fund that 21 brokerages are launching to directly buy shares. The Chinese press, which is to say Beijing, hinted that the stock market intervention could rise to 1 trillion yuan.
The Shanghai Composite opened nearly 8% higher Monday thanks to the intervention news, but the rise was met with selling and the index closed up just 2.4%, then the plunge quickly resumed as investors lost confidence that Beijing can halt the slide.
There are eerie similarities between Shanghai today and Wall Street in 1929. Eighty-six years ago, five of America’s most powerful financiers, led by J.P. Morgan, met in a smoke-filled room at 23 Wall Street to prop up the market after Black Thursday.
Initially, the plan sparked a recovery, and The New York Times reported a success in putting a floor under share prices. But it didn’t last, with the Dow plunging 34% lower over the next three weeks. Perhaps Beijing will ultimately be more successful today than Wall Street bankers in 1929, but so far the selling in China continues.
The selloff in Shanghai has so far wiped out more than $4 trillion in value from Chinese stocks, equivalent to more than one-third of China’s annual GDP! Yesterday, half the stocks listed in Shanghai and China’s Shenzhen markets were halted for trading.
But make no mistake, Beijing has a powerful arsenal of tools, including a war chest of currency reserves, at its disposal. This is still a command economy, after all. And volatile swings — both up and down — in Chinese stocks are nothing new.
Beijing has always been wary about speculation leading to unsustainably high stock prices, which is precisely why it acted last month to cool things down. Now realizing they may have overdone it, regulators are quickly moving to cut interest rates and ease lending requirements. As China transitions toward a consumer-led economy, a healthy stock market is a key requirement.
In addition to mainland brokers pledging billions to support stock prices, Beijing can also turn to wealthy Hong Kong investors and institutions to buy with government guarantees and there have been credible rumors of such arrangements.
For this reason, it seems to me the crash-analogy that fits Shanghai best today isn’t 1929, but 1987. The Dow lost one-fourth of its market value in just over a month, but within two years, stocks were again making new highs.
Investing in Chinese stocks is not for the faint of heart. Even China tracking ETFs have been clocked over the past several weeks. The DB X Trackers Harvest CSI China A Share ETF (ASHR), one of the largest tracking mainland shares, has plunged 32% since June 1.
Hong Kong shares have held (on the downside) relatively better than Shanghai, and for my money, this remains the preferred buying opportunity if you’re investing in China. The iShares China 25 Large Cap ETF (FXI) of Hong Kong listed shares is down 18.7% over the same period.
The selloff in Chinese shares is bringing market valuations back into the bargain range again, at least in Hong Kong. While the median price-to-earnings ratio in China has dropped to 53 from 108 at the height of the rally, valuations are still more than twice as high as the S&P 500 Index. Hong Kong looks far more attractive today — the China Enterprises Index is trading at just 8.6 times earnings, among the cheapest market in the entire world.