A Bad Year for Chinese Stocks
Looking back on 2013, it’s clear that it was not the year that China’s equity markets finally recovered. As several news articles have pointed out, China’s stock market was the weakest in Asia. Despite China’s continued robust economic growth, the Shanghai Composite Index ended the year down almost 7 percent. The continued dismal performance of the Chinese stock market challenges the commonly held belief that there is a positive correlation between economic growth and rising stock prices.
The index of the Shanghai Stock Exchange (SSE) makes the scale of the problem clear. The index of the market peaked in October 2007 at 6,092. As of the end of December 2013, the SSE index was 2,116, barely more than a third of the 2007 level. 2007 was clearly a bubble and out of step with fundamentals. The average price-earnings (P/E) ratio was an astronomical 70. But if anything the market overcorrected and now remains in a depressed state. The current P/E ratio of 11 seems far too low for a rapidly growing economy. Adding in the Shenzhen Stock Exchange brings the average up slightly to 14. For comparison the P/E ratio for the S&P 500 is currently 20.
The poor state of equity markets isn’t due to a lack of effort by authorities. Over the past several years there has been a flurry of new initiatives aimed at boosting shares. Former China Securities Regulatory Commission (CSRC) Chairman Guo Shuqing came into office in 2011 promising a host of new reforms aimed at investor protection and reducing insider trading. His successor Xiao Gang has continued most of these policies. State-owned entities such as the National Social Security Fund (NSSF) and Central Huijin continue to purchase shares when markets look weak. CSRC suspended IPOs between October 2012 and December 2013 in an effort to boost share prices. The most recent effort is the new set of regulations from CSRC aimed at improving small investor protection, an effort to entice back China’s retail investors who played an unusually large role in the previous stock market boom.
In terms of effectiveness, these efforts have been a mixed bag. The investor protections are positive but enforcement has been weak. The efforts to prop up stocks through share purchases have had the negative consequence of creating an expectation amongst investors that the government is responsible for managing share prices.
The macroeconomic consequences of dysfunctional equity markets are significant. Because most companies lack the option of seeking financing through equity, they instead turn to debt markets. This has been one of the factors leading to the rapid increase in China’s debt-to-GDP ratio. The equity share of total social financing was a measly 1.2 percent as of Q3 2013. At the height of the stock market in 2007, the share of equity financing was six times greater, but still low compared to less bank-dominated financial systems.
In general, it matters very little at the margin whether companies decide to finance themselves by issuing debt or equity. Optimal capital structures vary across companies and sectors, being heavily influenced by growth prospects and tax laws.
However, if debt levels reach a sufficiently high level, these financing decisions can matter quite a bit. Overreliance on debt increases the risks of financial distress and bankruptcy. Chinese corporations may be approaching this level, given their growing levels of debt and declining debt service coverage ratios.
This complicates the ongoing goal of interest rate liberalization, which was reemphasized during the Third Plenum. Corporate debt in China is high enough that an increase in interest rates could push many highly-leveraged borrowers into bankruptcy. This is especially true for many state-owned enterprises, which on average are more highly leveraged and have a lower return on assets. With some reasonable assumptions about the term structure of the existing stock of debt, a 1 percent increase in interest rates could lead to another 500 billion renminbi per year in required debt payments by nonfinancial corporations, equivalent to 5 percent of corporate profits.
China’s dysfunctional equity market reveals that the country is not immune from the boom-and-bust cycles that affect financial markets around the world. In some respects, the boom-and-bust cycle in China has been worse. More than five years after the bubble popped, the stock market is still far away from returning to its previous high. This contrasts poorly with the crash and subsequent recovery of the S&P 500 in the United States.
The growth of credit in China remains excessive. Well-functioning equity markets are one of the tools that will help reduce the overreliance on issuing debt. This brings in to focus how important fixing China’s stock market is to putting the Chinese financial system on a more sustainable path. Let's hope for a better new year for Chinese markets.