The view that the rapid run-up in Chinese stock prices since mid-2014 has been mostly driven by liquidity and hype ignores the importance of a strong stock market in advancing Beijing's financial reform.
In particular by channeling more household savings into equities and, hence, reducing the reliance of corporate funding on banks and shifting it to the equity market. A success transformation could lead to a fundamental re-rating of Chinese equities in the long-term.
Encouraging robust market sentiment helps Beijing to achieve a number of policy objectives, including:
- local government debt restructuring
- state-sector reform
- capital market liberalisation
- renminbi internationalisation
- economic rebalancing towards consumption-led growth
- lowering the cost of funding (via equity financing) for the private sector
EXAGGERATED BUBBLE CONCERNS
Worries about a stock market bubble propelled by margin-financing have been exaggerated. Despite the exponential rise in the A-share market, its market capitalisation is still only about 70 per cent of the country's GDP. This degree of equitisation of the economy is far below the 90 per cent in South Korea and 150 per cent in the US, for example.
Further, despite recent concerns about margin trading, it only accounted for less than 20 per cent of China's monthly equity market turnover in the first quarter of this year. This is much lower than the 31 per cent recorded in South Korea and almost 40 per cent in Taiwan.
And the Chinese authorities are not allowing margin trading to expand out of control; they have tightened up margin trading rules twice in the last five months, and will not hesitate to tighten them again if needed.
As argued recently, the sharp rise in A-share prices also reflects the rapid growth of China's nominal GDP, which has expanded by more than 350 per cent since 2005 (see chart 1 above, click to enlarge), before the onset of the last A-share rally.
Beijing's financial liberalisation process is likely to encourage more households to reallocate assets to stocks, creating a benign backdrop for boosting stock valuations over the longer term.
In China, the benefit of a strong stock market does not come from the wealth effect on consumption, as 1) China's marginal propensity to consume is very low (at around 0.34 cents per yuan increase in income); and 2) Chinese households hold only about 5 per cent of their total assets in stocks.
Rather, the gain mainly comes from the reduction of equity financing cost, which should help ease the financial constraints on small and medium-sized (private sector) companies.
Improving valuations typically facilitate corporate financing through IPOs and secondary placements. From a macroeconomic perspective, corporate debt-to-equity ratios should fall, reducing the economy's reliance on debt financing (including bank loans) and, thus, lessening overall economic risk.
China's equity financing has ample room to grow, as it only accounts for about 3 per cent of new aggregate (or total social) financing flows (see chart 2).
Of course, it is not always smooth sailing for reform and there are also risk implications from the bull market. Despite the still manageable size, rising margin debt is a potential risk because it links the banking system to stock market volatility.
To fund their loans to stock investors, brokers have borrowed in the interbank market. Any stock market volatility causing investors to default on margin loans will create a contagion effect on the banking system that is likely to be bigger than in previous cycles, as the system is now more exposed to the brokerage industry.
A more subtle risk is companies diverting capital into stock market speculation, using hard assets as collateral and borrowing from banks. With companies struggling to generate returns from their core business in a slowing economy, stock punting may become an attractive alternative in a rising market.
This makes corporate profits more dependent on the stock market's fortune, thus increasing the volatility of earnings. If the market reverses and the economy remains weak, earnings could suffer a double blow.
However, Beijing seems to believe that these risks are within controllable limits and are of secondary concern. Its primary agenda is for a strong stock market to facilitate structural reforms and revive the 'animal spirits' in the private sector so as to sustain a reasonable level of growth.
Chi Lo is senior economist for Greater China at BNP Paribas Investment Partners.