June 22, 2024

China stock rout shows investors want way more reform

The startling divergence between China’s 5.2% growth and cratering stock market is putting Asia’s biggest economy in global headlines for all the wrong reasons.

Given the chaos of 2023 — a massive property crisis, record youth unemployment, trade headwinds from Washington and deflationary pressures — China’s ability to top 5% growth year on year is impressive indeed. But the stock market continues to stumble, a rout that shows few signs of slowing.

So how bad could things get? In the first two weeks of 2024, global funds sold more than US$1.1 billion of mainland stocks. China’s CSI 300 index this week fell to its lowest levels since 2019, losing more than 25% over the last year. That’s the mirror image of the 24% rally in the S&P 500 over the same period.

China’s stock troubles have many causes. The most recent: disappointment that the People’s Bank of China didn’t loosen monetary rates this week. It left rates unchanged on its seven-day reverse repo and medium-term lending facility. Markets had been expecting cuts.

“The PBOC’s decision to hold rates is negative for market sentiment and economic growth, and suggests policymakers are not trying very hard to present a coordinated, strongly pro-growth message at the start of the year,” says Wei He, analyst at Gavekal Dragonomics.

Recent data show that China entered 2024 with a series of headaches undermining domestic demand and confidence. Property-related spending is sliding and home prices are the weakest since 2015.

Consumer prices have dropped for three consecutive months, suggesting the worst deflationary pressures since the 1997-98 Asian financial crisis. 

Then there are the data trends that fuel “Japanification” chatter. That includes news that the historic decline in China’s population continues, with births falling to a record low in 2023, adding to Beijing’s longer-term demographic challenges.

It’s complicated, of course. As 2024 opens, Xi Jinping’s China finds itself at a transitional crossroads. President Xi’s team has been working to reduce China’s vulnerability to boom/bust cycles.

This means clamping down on runaway borrowing, reducing the role of state-owned enterprises, championing private-sector development and increasing innovation.

Deleveraging is a necessary ingredient to increasing the quality and productiveness of China’s gross domestic product (GDP). It means going easy on the kinds of stimulus Beijing would normally throw at a lethargic economy.

This can be seen in the PBOC’s reluctance to hit the monetary gas. 

People’s Bank of China Governor Pan Gongsheng is reluctant to hit the monetary gas. Image: Twitter Screengrab

“We suspect the main reason the PBOC failed to deliver this time is a desire to avoid triggering renewed depreciation pressure on the renminbi,” economists at Capital Economics said in a note.

Along with hastened capital outflows, a weaker exchange rate would increase default risks among property developers already struggling to make offshore bond payments. It also might draw ire in Washington as the November presidential election heats up.

ANZ Bank analysts add that the “PBOC chose to hold despite strong deflation pressure. This likely reflects its concerns about bank profitability.” The rationale being that the lower rates go, the harder state-owned banking giants might find it to generate healthy returns.

Yet indications that China faces deflation buttress the case for additional monetary easing, says Commonwealth Bank of Australia strategist Joseph Capurso. “We judge the market has more or less priced in an imminent PBOC rate cut” in the near future, he notes.

Weak consumer demand is hardly helping to change the narrative among global investors. When it comes to spending, “sustainability is in doubt amid slowing economic recovery,” says Lillian Lou, analyst at Morgan Stanley.

Adding to the uncertainty at PBOC headquarters, Governor Pan Gongsheng has limited visibility into what the globe’s other top central banks are planning this year.

Bets that the US Federal Reserve would be cutting rates assertively are being reconsidered as the world’s biggest economy expands apace.

Top officials like Fed Board Governor Christopher Waller are signaling that rates will be lowered “methodically and carefully” at best. 

Such comments suggest “there’s no reason to move as quickly as they have in the past, cuts should be methodical and careful,” says strategist Marc Chandler at Bannockburn Global Forex.

At Bank of Japan headquarters, officials are stepping away from plans to exit quantitative easing. Along with likely entering 2024 in recession, BOJ officials worry China’s slowdown will hit Japanese exports hard.

All this “means that the market no longer expects the Bank of Japan to raise interest rates at its late January board meeting,” says economist Richard Katz, who publishes the Japan Economy Watch newsletter.

“That, in turn, means the US-Japan interest rate gap will remain higher for longer than was previously expected, or grow even larger as it has over the past weeks,” Katz says. “If so, that means a weaker yen than previously expected.”

This dynamic could complicate the PBOC’s options for major steps to add liquidity. Gavekal’s He says that “policymakers are still likely to reduce policy rates later in the first quarter, meaning bond yields will probably remain at their current low levels.”

PBOC officials, He adds, “are unlikely to change the benchmark loan-prime rates later this month.”

“Commercial bank net interest margins remain at an all-time low, and it is hard to imagine that policymakers would exacerbate that squeeze by lowering bank lending rates but not their funding rates. Still, bond-market participants appear optimistic about an eventual rate cut,” He adds.

Thanks to looser liquidity conditions, lower deposit rates and rate-cut expectations, the 10-year China government bond yield has declined to about 2.5% from nearly 2.7% in early December.

Lower yields are narrowing the gap between the 10-year Chinese government bond yields and seven-day reverse repo rate, a measure of growth expectations.

“It is now nearly back to the average in 2022, when Covid lockdowns hammered the economy,” He notes. “The already low-level means room for further narrowing is probably limited, barring a substantial shock to growth.”

Li Qiang has stood by the line that massive stimulus is not on the way. Image: Screengrab / NDTV

Speaking in Davos this week, Chinese Premier Li Qiang gave few hints that Xi’s inner circle expects major shocks. There, Li stuck to the line that Beijing isn’t about to announce “massive stimulus” moves to boost growth or combat deflation.

To be sure, China is mulling a special sovereign bond scheme to issue 1 trillion yuan ($139 billion) of new debt. The idea would be to sell ultra-long sovereign bonds to improve efficiency in sectors like energy, food, supply chains and urbanization planning.

But the real reasons so many global investors wonder if China is safe are an underdeveloped financial system and regulatory uncertainty.

As Bloomberg reports, SC Lowy Financial HK Ltd finds the “credit space uninvestable there” due to murky legal certainty and poor corporate disclosure. Thus, the investment firm has “very little exposure to China.”

At Davos this week, JPMorgan CEO Jamie Dimon told CNBC that the “risk-reward calculation” on China has “changed dramatically” despite Xi’s team being “very consistent” in opening up to financial services companies. That, he added, leaves global funds “a little worried.”

In the short run, Beijing is asking institutional investors not to dump large blocks of Shanghai or Shenzhen stocks. Regulators also are working to curtail big investors’ ability to be net sellers of shares on certain days.

As the Financial Times reports, this so-called “window guidance” is being pursued to calm nerves in both equity and debt markets. Yet this treats the symptoms of Chinese stock troubles, not the underlying causes.

The need for a clear and bold commitment to structural reforms was crystalized by a December 5 downgrade warning by Moody’s Investors Service.

It lowered Beijing’s credit outlook to negative from stable citing “structurally and persistently lower medium-term economic growth” and a cratering property sector. But also, because of China’s increasing financial volatility.

Xi and Li know what’s needed: greater government transparency; better corporate governance; more reliable surveillance mechanisms; a credible independent credit rating system; and a robust market infrastructure that keeps foreign investors engaged.

True, Moody’s noted that the “economy’s vast size and robust, albeit slowing, potential growth rate, supports its high shock-absorption capacity.”

Yet a bewildering array of headwinds slamming cash-strapped local governments and SOEs are “posing broad downside risks to China’s fiscal, economic and institutional strength.”

To its credit, China has made vital progress since 2016 to make its markets more hospitable to overseas investors. That was the year the PBOC secured a place for the yuan in the International Monetary Fund’s “special drawing rights” program.

The yuan’s inclusion in the IMF’s exclusive club of reserve currencies, joining the dollar, euro, yen and the pound, was a pivotal moment for Beijing’s financial ambitions.

In the years since, Xi’s team vastly increased the channels for foreign investors to tap mainland stock and bond markets. Shanghai stocks were added to the MSCI index, while government bonds were included in the FTSE Russell benchmark. among others.

China has resisted depreciating the yuan. Image: Twitter Screengrab

As demand for the yuan and its global usage in trade and finance grows, China’s tolerance for a stronger currency has surprised markets.

Perhaps no policy lever would hasten Chinese growth faster or more convincingly than a weaker exchange rate. However, Xi’s Ministry of Finance has avoided engaging in a race to the bottom versus the Japanese yen, earning it points in market circles.

Yet the opacity that still pervades Beijing decision-making and Shanghai dealing remains a turnoff for all too many global punters.

Not all, of course. JP Morgan strategist Marko Kolanovic thinks the big drop in Chinese equities is “disconnected from fundamentals” and buying opportunities abound.

“We believe this is a good opportunity to add given an expected growth recovery, gradual Covid reopening, and monetary and fiscal stimulus,” Kolanovic says.

The odds are even greater, though, that China’s stock rout deepens further as Xi and Li navigate this transitional moment.

At some point, China will fix the property sector and build broader social safety nets to increase consumption. And its capital markets will one day be ready for global primetime. In the meantime, the CSI 300 could be in for quite a rocky ride.

Follow William Pesek on Twitter at @WilliamPesek

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