Notwithstanding the continued uptrend in major international equity indices, the Chinese equity market lost 21.81% in August, compounding investors’ fears over the country’s economic outlook. Not only did these fears (which were only partially dispelled by a recovery towards the end of last week) weigh on the equity indices of other emerging markets, but also on leading international equity markets. Although the decline in the Chinese stock market was not the main trigger for the downtrend in western equity markets, which was due to persistent doubts over the sustainability of the current economic upturn, it certainly played a role in it.
Both the decline and the upsurge of the Chinese market have been mainly sparked by the sharp increase in liquidity and bank loans due to expansionary monetary and fiscal policy implemented by the Chinese Central Bank. Indeed rumours circulated in August that the Bank is highly likely to tighten its monetary policy in the second half of 2009. Based on data released by the China Business News, as much as 20% of the largest loans granted in the first half of this year have been invested in the Shanghai stock market. The latest press rumours suggesting that new loans slumped to 300 billion yuan in August from 356 billion yuan in July and an average of 1.231 trillion in the first half of the year have reinforced fears of a slowdown in liquidity growth.
Worries about a possible exit from the current accommodation have led investors to play down encouraging signs of an early recovery in the real economy. The manufacturing PMI hit 54 in August, its highest for the past 16 months and a figure suggesting positive growth in the manufacturing sector.
Robert Zoellick, World Bank president, said that the outlook for the global economy has improved recently thanks to reassuring signals coming from China. The World Bank president also confirmed that the Chinese economy is expected to grow by 8% in 2009, but he recommended not to remove the monetary stimulus as the economic recovery is fragile and inflation is not cause for concern at present.
In an article published on his website (http://www.mpettis.com/), Michael Pettis, professor of finance at Peking University and one of the foremost experts on the Chinese economy, confirmed that the market decline was due mainly to factors related to developments in speculative liquidity. “Why did the market collapse? Forget about fundamentals. As I have argued many times before, China lacks the necessary tools that fundamental investors use (e.g. good macro data, good financial statements, a clear corporate governance framework, a stable regulatory environment, a market discount rate) and so no matter what people say, there are no fundamental investing here. There is only speculation, and the two things above all that drive the markets are those old speculator favorites, changes in underlying liquidity and government signaling". The weak correlation between economic fundamentals and stock markets’ trend in emerging countries has been also underlined by Paul Marson, CIO of Lombard Odier, in a recent article published in the Financial Times.
China’s Premier Wen Jiabao, following the declines of recent weeks, gave a
speech on Tuesday September 1st (the day after the 6.7% drop in the stock market) to assure that the expansionary monetary and fiscal policy will not be removed shortly as the recovery is still at a critical point. The market response to Wen Jabao’s speech has been positive, with the Shanghai market index partially recovering the ground lost on Monday 31 August.
Moreover, a further slump in the Chinese equity market would hamper the effectiveness of the stimuli implemented recently by Beijing. For this reason, Pettis believes “that if the local stock markets do not soon recover their bounce (and they won’t without government help) and, even worse, if we start to see the awful sentiment seep into the real estate sector, Beijing will once again push forcefully for credit and fiscal expansion”.
Pessimistic about the outlook for the Chinese stock market is Andy Xie (Andy's article published in August), a former chief economist for the Asian economies at Morgan Stanley and now an independent analyst. According to Xie, it is very likely that both the stock and the real estate market are in a new bubble. "Chinese asset markets have become a giant Ponzi scheme. The prices are supported by appreciation expectation. As more people and liquidity are sucked in, the resulting surging prices validate the expectation, which prompts more people to join the party. This sort of bubble ends when there isn’t enough liquidity to feed the beast”. However, current liquidity levels are not cause for concern. Xie, who considers the equity market 25% overvalued and estimates that it will fall below the 2000-point threshold, believes that the stock market can continue to hover around these bubble levels for some time to fall permanently in Q4 or during next year. The main trigger for the downturn should be a strengthening dollar, historically a source of danger for the emerging markets, which should be underpinned by a rise in interest rates as a result of a possible higher inflation.
Overall, the outlook for the Chinese stock market is clouded in uncertainty. Although the strong liquidity injection will likely support the equity market in the short term, the inevitable withdrawal of excess liquidity will have negative effects on Shanghai going forward. And the severe repercussions of excess credit and liquidity on western economies are still there for everyone. For these reasons, staying away from the Chinese equity market will prove to be the wiser choice for European investors (by contrast it could be a golden opportunity for traders due to its high volatility). However, the trend shown by the country’s equity market in the last few days is clear evidence that the decline in the Chinese stock market will certainly impact on western European markets. European investors are highly recommended to give every morning a look at the Chinese stock market close.