China: Stock market selloff raises fears of financial crisis
July 10, 2015
Stock markets in China tumbled in recent weeks, sparking concerns that the country could be teetering on the precipice of a financial crisis. On 8 July, the Shanghai Stock Exchange Composite Index (SHCOMP) accumulated a loss of 31.7% from its mid-June peak. The massive selloff, which mainly reflected a rapid deleveraging process, followed a sharp rally in the stock markets in the previous 12 months. The SHCOMP had accumulated an annual gain of about 150% by mid-June as a result of rising investor confidence due to the People’s Bank of China’s ongoing monetary stimulus, large initial public offerings (IPOs) and new mechanisms that investors used to purchase shares on credit (margin financing). Against this backdrop, authorities decided to take action to cool down the stock markets, mainly by tightening regulation and reinforcing supervision. As a result, companies started to unwind their positions, particularly for margin financing, putting downward pressure on the stock market. According to some estimates, the balance of margin financing outstanding fell from CNY 2.3 trillion in mid-June to CNY 1.5 trillion as of 8 July.
In an attempt to stabilize the stock markets and shore up investor confidence, Chinese authorities unveiled a raft of measures at the end of June and early July, including a ban on new IPOs, a simultaneous cut in the reserve requirement ratio and the benchmark rates, purchases of shares by government-controlled institutions, the prohibition of selling shares from large stakeholders, and the injection of liquidity into the financial system, among others. These measures helped lift sentiment, and the SHCOMP rebounded strongly in the next few days.
Despite the improvement observed in recent days, questions remain about whether the recent slump in the stock markets could hamper growth and financial market stability. Analysts believe that the impact of the market turmoil on households will be limited as Chinese citizens’ participation in the equity market is relatively low (less than 7% of the population) and stocks represent a small share of households’ wealth. Moreover, it is worth noting that the 30% drop in the stock markets followed a 150% rally in the July 2014–June 2015 period, suggesting that many investors still had positive returns. Regarding corporate financing, the collapse in the equity market could derail Chinese authorities’ efforts to encourage firms to move away from bank lending as their main resort for financing.
Overall the Chinese economy is strongly shielded against a sharp downturn in the financial sector due to the government’s sound fiscal position, low external debt, massive foreign exchange reserves and a solid current account surplus. Therefore, the possibility that China could slip into a financial crisis seems very low. That said, some analysts believe that the turmoil in the equity market could handicap structural reforms. As Wang Tao, Chief China Economist at UBS points out:
Could the recent market turmoil delay some reforms? Equity market gyrations and the recent suspension of IPOs will likely impede capital raising and M&A activities, potentially delaying the implementation of equity incentive plan and mixed ownership reform of SOEs as well as their divestment by local governments. […] The government may also take a more cautious approach regarding capital account opening, given that too rapid an opening may further amplify domestic fluctuations, especially given fragile fundamentals and flawed regulations. On the latter, we have always held the view that capital account convertibility should not speed up until more progress has been made in domestic SOE and financial sector reforms.