by George W. Russell
The volatility of the Mainland stock markets has astonished investors and has had deep knock-on effects throughout the world. But, as George W. Russell reports, financial professionals are optimistic – provided Mainland companies can develop better corporate governance to withstand future shocks.
Ferdinand Pecora, a prosecutor appointed by President Herbert Hoover of the United States to investigate the causes of the epic 1929 Wall Street crash, lamented at the knowledge of the average American investor. “The exchange was… a glorified gambling casino where the odds were heavily weighted against the eager outsider,” he concluded in his 1933 report.
More than 80 years later, the recent rise and fall of the Chinese stock market is being partly blamed on a new generation of “eager outsiders,” an estimated 15 million individual investors in the Mainland who have opened trading accounts in the past year and a half.
The US$3 trillion value wiped off Chinese stocks in June and July is not just paper losses. The meltdown caused wobbles in the Hong Kong market, and put at least a temporary hold on billions of dollars in planned foreign investment. The knock-on effects were widespread, ranging from curbing Mainland new car sales to dampening Australian luxury property prices.
Even doctors and newspaper medical advice columnists have had to weigh in, warning of the perils of “stock market anxiety syndrome” that creates physical suffering in investors, such as nausea and insomnia, as well as anxiety, nervousness, irritability and other mental issues.
It is therefore perhaps unsurprising that the Chinese government took action. The People’s Bank of China cut interest rates, and most short-selling has been banned. Other moves are largely unprecedented in major stock markets: IPOs have been halted and brokerages have been compelled to begin buying shares and refusing to honour sales orders. “We have the conditions, the ability and the confidence to preserve stock market stability,” a People’s Daily editorial insisted.
At press time, the market had been stabilized, though few have predicted the long-term repercussions of the government actions. Many have drawn parallels with the 1929 U.S. crash, when the Hoover administration pressured J.P. Morgan and other bankers to buy shares and put a floor under prices. America fell into a recession nonetheless.
Although roller-coaster rides are always a cause for concern, some market experts point to China’s more encouraging broader picture, with government policies guiding the country towards a needed economic transition. “There is a larger fundamental trend of reform, which can allow the economy to gradually restructure and repair itself from some of the excesses which have accumulated over the past five years,” says Timothy Moe, Managing Director and Chief Asia- Pacific Regional Equity Strategist at Goldman Sachs in Hong Kong.
The iconic image of the 2015 crash in China is a dismayed person standing in front of an electronic stock price display. These lone individuals represent the archetypal Mainland retail investor. According to Shanghai Stock Exchange data, individual investors owned 81 percent of tradable shares by market capitalization in July 2014.
While the number of individual share accounts has undoubtedly increased – 38 million were opened in the second quarter of this year, compared with 9 million in all of 2014 – China’s 91 million individual investors also include some of the country’s richest people and most sophisticated investors, many of whom have multiple accounts.
Many were encouraged to open accounts by a government campaign urging more stock market participation by ordinary Chinese. In 2014, authorities cut trading fees, made it cheaper to open new accounts and staged investor presentations by the biggest listed banks. “If you ask how the market went up so far I think one of the key drivers was lots of positive news,” says Edmond Chan, Co- Head of Capital Markets Services at PwC and a Hong Kong Institute of CPAs member.
However, the pool of individuals now counting their losses is large enough for the government to be concerned about social stability in the wake of a prolonged or deep crash. “I think we probably can appreciate that the China Securities Regulatory Commission would have liked the stock market to stay healthy, otherwise you could have 90 million angry retail investors,” says Michael Cheng, Research Director (China and Hong Kong) at the Asian Corporate Governance Association.
Authorities are concerned that new investors in the market make investment decisions without properly interpreting market indicators. (The Financial Times recently reported on an investor new to the market who took punts based on Chinese leaders’ birthdays).
“Individual investors often have a different view of the market,” notes Edward Au, Partner and Co-Head of the National Public Offering Group at Deloitte and an American Institute of CPAs member. “They might not have access to good information.”
New investors also have little appreciation of the inherent dangers. “Knowing one’s tolerance for risk is critical to investing successfully in any market,” says Nick Ronalds, Managing Director and Head of Equities at the Asia Securities Industry and Financial Markets Association, a Hong Kong-based trade body. “Investors who are comfortable with their level of risk can sit tight through the ups and downs.”
One way to lighten the risk is to improve corporate governance of A-share companies. “This is a very good opportunity to take a hard look at governance in China and how governance levels are being maintained, especially since the Shanghai-Hong Kong Stock Connect starting last November,” says Cheng at ACGA.
Rebecca Chan, Partner and Head of Hong Kong Capital Markets at KPMG China and an Institute member, notes that the Shenzhen-Hong Kong Stock Connect, scheduled to launch this year, will further widen the market coverage and penetration that the Shanghai-Hong Kong operation has currently achieved.
The introduction of the stock connect schemes are catalysts for internationalization, she says. “Their main goal is better integration of stock markets across the region.”
However, foreign institutional investors have approached Chinese markets cautiously. “Institutional investors are valuation sensitive,” says Michelle Leung, Chief Executive Officer of Xingtai Capital, an investment management fund based in Shanghai, who watched the Mainland bull run with concern. “Valuations had run up too much and the market was due for a correction.”
Cheng at ACGA notes that many listed enterprises in China saw their stock price enhanced irrespective of their quality of corporate governance, but he sees improvement in the near future. “I think we are seeing very encouraging early signs of shareholder engagement and institutional participation,” he says.
As evidence, he cites more and better disclosure on both the Shanghai and Shenzhen exchange websites, although language is a concern. “Please make more of them in English,” he urges. “That’s a real problem for global investors, and now that you have mutual connectivity, shouldn’t you be ensuring more disclosure to be readily comprehensible by the global investor audience?”
Cheng says China’s main securities regulator has kept up the pace of listed company rules reform. “I have to congratulate CSRC for enforcement on insider dealing,” he says. “They are really trying hard to give the global community confidence.”
However, he says, there is room for improvement, such as more oversight of shareholders’ meetings to ensure that minority shareholders can attend and vote. “CSRC put out regulations in May that require separate counting and disclosure of minority votes,” he says. “But voting by proxy still encounters challenges, such as votes against the board being rejected or pressure being applied to change ‘no’ votes into abstentions.”
China is still dealing with the fallout from the market plunge: yields on benchmark bonds have risen sharply, while the Chinese currency slumped in offshore markets. Highly leveraged investors, desperately seeking cash to repay loans, sold off futures, causing commodities from eggs to steel to hit new lows.
However, while some experts believe the failure to hold up equity markets could hamper broader economic liberalization, others believe further reforms are inevitable. “In China any reform will be a step-by-step process,” says Chan at PwC. “But it all points in one direction – more internationalization.”
Policy-makers hoping for a less volatile stock market that is more amenable to companies raising more equity capital and reducing their reliance on bank loans, will probably have to wait. “I think we will continue to see more high volatility,” says Chan. “China has more individual retail investors and they make the market more volatile. Investor education will take some time and it is part of the process.”
Margin trading – borrowing money from a broker to purchase stock – is also likely to evolve. “Margin trading creates leverage and magnifies returns as a market rises, but also increases the risk of loss in a falling market,” says Ronalds at ASIFMA. “The authorities will doubtless seek to limit the risk investors can take on.”
Chan at PwC argues in favour of properly supervised margin trading. “Look at it from a capital markets perspective,” he urges. “Margin trading is a normal product offering. But it should be properly monitored and people should understand the risks. I hope margin trading will be put on the right track and help the capital markets be more solid.”
On the question of how A-shares can experience more stable growth in the long run, Ronalds looks to the benefits of a broader investment base coming from outside the Mainland. “A diversity of investors pursuing a range of different strategies will sustain a healthy stock market and contribute to sound capital markets in China,” he says. “Some technical reforms, such as fostering a well-functioning stock borrowing and lending regime and the ability to sell short efficiently, would also help attract more investors and encourage efficient pricing of stocks.”
Although U.S. efforts to prop up Wall Street after the 1929 slump were in vain – the crash presaged a decade of depression – economic fundamentals suggest China is unlikely to suffer the same consequences. However, as Leung, the fund manager, points out: “Ultimately, the health of the stock market is directly correlated with the health of the economy. The government needs rebalance and reform.”
This article was originally published in the July 2015 edition of A Plus. You can find the pageflip version here.