A steep fall in the stock market this summer provoked the Chinese government to act to shore up values. The subsequent volatility has highlighted the need for foreign investors to take account of the political risks of doing business in China, and not just assess the fundamentals of the business in which they invest – or face significant losses.
The Rise and Fall of the Share Market
China’s markets have had a giddy year. The Shanghai Shenzhen CSI 300 rose from 2,400 points in November 2014 to a high of over 5,300 in June 2015, driven uphill by a steady drumbeat of support from the state media. This hike owed much to margin borrowing by some 91 million retail investors, and bolstered efforts to recapitalise companies by raising the value of collateral.
Over the course of June and July that all changed, though. Sentiment turned, a retreat became a rout, and by late August, the market had lost all gains in 2015; as margin borrowing had goaded values uphill, now it harried them down. Volatility in daily trading has been huge, with market shifts of 8% or more on occasions.
The government was initially nonplussed, but in June decided to intervene to shore up valuations. Its initial efforts to stem the retreat were not successful, though, and so over the following months government agencies introduced ever more invasive measures, including: a decision to effectively halt IPOs; increased funding for the margin borrowing that fuelled the boom; interest rate and reserve ratio cuts; the adoption of rules that oblige purchasers to hold shares for a longer period; the suspension of trading in many stocks; the imposition of obligations on brokerages and state owned enterprises (“SOEs”) to buy shares; and plans to introduce circuit breakers that limit volatility.
The necessity of such measures was not entirely clear, as share prices had risen very high, and a correction was obviously due. Even so, the PRC government feared that any stock market crash might represent a direct threat to social or economic stability. State media consequently cheered on a “national team” seeking to prop up the market.
At What Price?
Some financial institutions have highlighted the costs of government intervention. One U.S. investment bank estimated that the government by early September had spent more than USD236 billion; money now reduced in value and locked into the market. Nor is it only the government that has had to cough up. In early July, 21 brokerages undertook, on government suggestion, to buy shares worth 15% of their assets; more volunteered to do so, and that sum has since increased.
In addition, a media campaign against ‘malicious short selling’ has preceded Ministry of Public Security investigations into the securities sector. Arrests have followed of senior officials at CITIC Securities, and a journalist at Caijing Magazine, Wang Xiaolu, who confessed on television to stoking panic through his reports. The authorities also seemingly summoned Li Yifei, a senior executive at hedge fund Man Group to a meeting.
These measures have slowed the rout, but they have also affected China’s stock markets. Liquidity has all but dried up at the China Financial Futures Exchange. Faith in the markets has slipped; domestic retail investors feel disappointment that the rises promised have not come to pass; and foreign investors see the intervention as a departure from market principles and has caused question as to the nature of the PRC market.
Hinting at a Trend?
The intervention also sends some signals about broader policy. After all, these regulatory measures contradict government comments about reforms and add to confusion about statements in other areas. For instance, the government agreed in November 2013 to reform the state owned enterprises (“SOEs”), but has since merged some companies, notwithstanding the risks that consolidation will almost certainly accentuate inefficiencies.
The volatility in the stock market has thus underlined why it has never been more important for investors to take account of political risks when investing in China. Its stock markets are not like those elsewhere despite that many U.S. investment banks may have advised international investors to the contrary.
All told, this situation presents investors with a wide range of risks, including:
- The intervention has highlighted how investors in China cannot simply examine a company’s fundamentals. They must also assess government policy, paying attention as to whether sudden shifts will affect an investment’s value.
- The criminal investigations demonstrate how sudden regulatory changes can present serious, even criminal, risks to a business or its personnel. These risks are especially worrying as hitherto common forms of market activity including short selling, can become unacceptable overnight – and on a backdated basis.
- The intervention has demonstrated how government action in China can affect sectors well beyond the target in question. One result of the stock intervention has been diminished liquidity that could result in an uptick in bad loans.
In this context, investors should monitor the policy outlook intently, and carry out thorough due diligence into a business and its principals, taking account of political and regulatory risks as much as commercial concerns.