Summer this year did not start with the usual lull. The stock market plunge in mid-June has put China in the centre of attention. After just two weeks’ respite, the Shanghai composite index fell by 8.5% on 27 July – the largest single-day drop since February 2007.
The market has since stabilised on government intervention.
The stock market turmoil has no evident wealth effect on the economy because less than 10% of households invest in stocks, involving a small share of their total assets.
The Chinese economy is still set for a soft landing this year, balancing on one hand a sustained property market recovery and accommodative economic policies and on the other hand structural constraints like overcapacity and debt overload in the heavy manufacturing sector.
However, the turmoil may have increased the tail risk for Chinese growth through the indirect impacts.
The stock market crash may have serious indirect implications
Our biggest concerns for the Chinese economy are the credit and property bubbles.
Both are large enough to trigger a hard landing in China, that is, an abrupt drop in growth.
The risk of either bubble bursting has increased lately as they have become more closely linked to the stock market.
A direct link between the equity and housing market was created when retail investors were granted permission to use their housing as collateral for the margin debt used in equity investment.
It means that if stock prices fall enough, individual investors could risk losing their homes to a broker. Given the economy’s heavy reliance on the housing market, this link could be risky for growth.
The link between the equity and credit bubble is through margin debt as well.
It is commonly believed that most liquidity from monetary easing over the past year went to the equity market.
Corporates may have played a major role here as they are the primary borrowers from the banks. The degree of corporate involvement in debt-financed equity investment is highly alarming given the pressure on corporate profits and the already high debt level.
We expect the authorities to use every tool at their disposal to prevent the stock market crash spreading to the property and banking sectors.
However, the latest stock market volatility has shown that the government does not always have a firm grip on the economy and the market.
What is the government going to do about it?
According to rumours, the large plunge on 27 July was due to the regulators’ secret withdrawal of the emergency measures, which have been in place since late June, to test market resilience.
Regardless of the rumour’s reliability, the authorities are likely aware by now that the stock market remains highly anxious.
The trailing 30-day volatility in the Shanghai composite index is 60, the highest since 1997 and many times higher than the SP500 volatility of 12 and the FTSE100 volatility of 15.
Therefore, the supportive measures will likely be kept in place for some time, including a sales ban for investors holding more than 5% of a company’s stocks.
Sovereign wealth funds would stand ready to inject more funds into the market.
Monetary policy will remain loose to prevent a third round of stock market crash and support growth.
We expect a few more cuts to the reserve requirement ratio, which is high by historical standards. We have revised our expectation and now expect one more rate cut of 25 bp in H2.
This revision is mainly based on the expectation of renewed downward pressure on oil prices, as a result of the fragile Chinese demand and lifted sanctions on Iran that could exacerbate oversupply, but also the heightened state of alert among Chinese leaders that is bound to have been the consequence of the equity drops.
On the fiscal policy side, approval of new infrastructural projects is expected to speed up.
The CNY (yuan) has been surprisingly stable since early June, despite indication of outflows from the equity sell-off.
It was likely a result of heavy government intervention, reflected by the falling FX reserves. CNY stability is preferred at the moment because Beijing cannot handle volatility in both the stock and currency markets.
In addition, the hope of being included in the IMF’s SDR basket in October also requires yuan stability.
In late July, the powerful State Council (Chinese Cabinet) recommended a widening of the CNY trading band.
Although this has sparked bearish bets against the CNY, it could be another move to liberalise the currency, another prerequisite for the SDR inclusion.
Conclusion: the equity sell-off and the possible chain reaction should have us worried
In spite of a robust property market recovery, the Chinese economy remains vulnerable.
Downside risks to growth have increased in light of the recent stock market crash, which may have contagion effects on the already large property and credit bubble.
Due to the rising growth concerns, the government will likely keep all supportive measures in place. More stimuli are expected, including one more rate cut of 25 bp in H2.
In the coming months, a firm CNY is preferred for the purpose of financial stability and SDR inclusion.
If the CNY trading band is to be widened, the aim would be to show progress on financial reform.