Quick Hits on Monday’s Drop

  1. This absolutely did not happen without at least implicit official sanctioning. Government has threatened traders, banned key stakeholders, and endowed CSF with virtually unlimited money to buy the market.  Even the major red chips were limit or near limit down.  This absolutely did not happen without official (in)action.  Maybe CSF regulators were just asleep during the afternoon trading session, who knows right now, but this absolutely did not happen in a vacuum.
  2. I would expect the market to stabilize Tuesday maybe even bounce a little. I would be very surprised to see another drop.  Beijing is fighting enough of an uphill battle with the stock market.  If they let it pick up some momentum, they just might get buried underneath it.  Look for significant resources to enter the market Tuesday.
  3. The market told you what it thinks of the market…..and it isn’t good. Unless Beijing is prepared to dedicate enormous amounts of money or bailout out all stockholders, it is only standing in the way of the correction.
  4. Beijing trying to buoy the stock market is not about political credibility, it is about financial viability. The sheer number of firms still suspended, most of them because they would be in technical default or be required to post new collateral, should tell you something. That would trigger additional selling, defaults, and other nasty stuff.  Further drops are going to push capital to leave the country as foreign capital isn’t even entering anymore.  This has the very real possibility to metastasize into a grade A economic and financial problem.  This is not political.
  5. Beijing always things that they have stopped a problem but are always a few steps behind. Due to the trapped capital, 10% trading limits, suspended trading in firms, and short selling bans, just to name a few, traders have taken to shorting other assets or shifting their capital.  According to one report, nearly $250b left China in the second quarter when the stock market was booming for most of that time.  Imagine how fast capital will flee if the stock market is not booming. Then it appears that China bears are turning to almost anything linked to China they can short, such as copper and yes, that includes Chinese traders.  Beijing: killing one market only creates other markets.  People and firms will find ways to make money and move their capital.  Even you cannot control a modern financial market by fiat.
  6. Chinese economic weakness is showing signs of spilling over into other emerging markets. Malaysian and Indonesian currencies are back to their 1998 crisis levels and imports from a range of other countries, especially lesser developed commodity exporters, is falling fast lowering growth and increasing credit strains.  Though unlikely to impact Japan, Europe, and North America, the Chinese story will have an enormous impact on emerging markets specifically in Africa and Asia.
  7. Ever ask why those remaining firms with suspended trading are still suspended? Though speculation on my part, I’d bet that these firms would be in default or be required to post additional collateral for loans they took to either play the market or used their own stock as collateral. The fact that so many remain suspended narrows the focus to non-general market concerns but why are those specific companies not trading.  Given what we know about their indulgence in stock pledging, it is worth considering these firms are staying suspended for a reason.  If there are serious problems with this many companies, this means enormous problems not just for the market but all of China.
  8. Quote of the day from China: “On Monday, Zhu Baoliang, director of economic forecast department of the State Information Centre, a government research agency, told Reuters the stock market crash was having a deep impact on the real economy and that it was essential for the authorities to cut interest rates and loosen monetary policy further.” First, apparently Mr. Zhu has not talked to his PR and own statistics bureau. China is achieving 7% GDP growth and anyone who says otherwise is mocked and ridiculed by the Global Times and the China Daily. Second, apparently Mr. Zhu needs a basic introduction in macro-economics. Lowering interest rates is going to place enormous stress on the RMB/$ peg and further pushing capital to leave the country. Third, in breaking news, apparently Mr. Zhu has been re-assigned to a county statistics bureau in Inner Mongolia.
  9. Apparently, the Chinese public has a better grasp of economic theory than its leaders. Chatter has been questioning 10% daily limits and whether this prolongs panics and volatility. Empirical academic works has consistently found that limiting price discovering increases volatility.

Be Careful What You Wish For

The Chinese government has imposed its will on the Shanghai and Shenzhen stock “markets” as both have stabilized since their precipitous late June and early Jul falls.  This stops the bleeding and neutralizes the fear that the market is going to get beaten down like a Chinese lawyer.  However, this presents a whole new set of challenges for Beijing and further restricts its policy options.

FT Alphaville describes the problem using dense, highly complex, and technical analysis from The Simpsons to describe the problem.

Skinner: The Lizards are a godsend.

Lisa: But isn’t that a bit short sighted? What happens when we’re overrun by lizards?

Skinner: No problem. We simply unleash wave after wave of Chinese needle snakes. They’ll wipe out the lizards.

Lisa: But aren’t snakes even worse?

Skinner: Yes, but we are prepared for that. We’ve lined up a fabulous type of gorilla that thrives on snake meat.

Lisa: But then we’re stuck with gorillas!

Skinner: No, that’s the beautiful part. When wintertime rolls around, the gorillas simply freeze to death.

Beijing is enacting a Simpsonian financial policy to contain the stock market fall.  While public purchases stabilize the prices, it creates a potentially even bigger set of problems later and I won’t even address the most obvious moral hazard.

First, given the near complete policy against selling stocks for brokers, insiders, key stakeholders, asset managers, and others which comprise a large portion of recent buying, how can these firms sell without pushing the market down?  This policy is essentially locking up a large amount of stock market and financial liquidity which does push the price higher, but also creates the problem of what happens when firms want or need to sell.  Market volatility in China and the relatively low level of free float implies that large institutional sellers exert enormous downward price pressure.  While the price problem has been stopped in the short term, it has created the problem of unraveling this buying spree by an institution that moved the market.

Second, given the rapid rise in associated debt with the stock market, especially with firms who became dependent on the stock market for profit growth, what happens to this debt given the near criminal prohibition on selling? Given the near perfect correlation between margin debt and the stock market, the debt can only be reduced by selling stock to pay of the debt.  However, selling puts downward pressure on the price.  Additionally, the interest rates on margin loans are relatively high by some accounts approximately 20% for retail investors though likely significantly lower for large companies and SOE’s.  Unless Beijing opts to simply freeze debt and roll it over indefinitely, to avoid having to sell stock pushing the market down which it has done to some degree, that debt is going to remain in a state of suspended animation.

Third, given the policy freeze on sell side liquidity and the encouragement to tie up bank and financial liquidity it stock based lending, how can liquidity be increased without prompting a decline in multiple asset classes?  The entire China economic growth story is built on selective liquidity restrictions to achieve political objectives.  Banks are built upon restricting lending to small and medium size enterprise for the benefit of large SOE’s. A large percentage of the stock market is essentially frozen for fear of collateral calls on debt and jail terms.  Encouraging banks to pump liquidity into the stock market via various loan mechanisms to buy stocks they cannot sell, already an incredibly risky gambit, saps liquidity from the provincial bond market bailout which is supposed to increased to an eye catching 3.6t rmb.  As all current liquidity is coming from the government and government mandates, loosening liquidity requirements run the very real risk of challenging many markets.

Fourth, as the public buying is an attempt to restore market confidence and bring investors back, what happens if hoped for non-public euphoric buying fails to materialize?  Capital is flowing out of China at an unprecedented rate and foreign investors want nothing to do with the Beijing sponsored casino.  This will require enormous public capital to even sustain the market lacking large inflows of private capital much less push it to pre-fall highs. It is questionable whether even Beijing has the willingness to act as the buyer of last resort at specified prices in the stock market.  While Beijing has arrested the decline in the stock market, there is little evidence Beijing has thought through how to extricate itself from this morass.

The China Securities Finance Corp with the eye catching 3 trillion RMB purchasing facility will likely stabilize the market but then what?  There is no evidence that firms or individuals unrelated to the Chinese government are piling back into the market to drive up prices.  All upwards pricing pressure on stocks is coming from public or quasi-public funds.  Even recently, CSF and related entities had to announce they had no exit plan for fear of prompting a market collapse.

There is currently no stock market right in China, there is government mandated price level in stocks.  While that may stabilize the price level in stocks, as the only real market participant Beijing got its wish but now needs to figure out how to extricate itself from a mess of its own making, and keep the market buoyant.  Any hint of public selling will incur enormous losses for Beijing and the state owned banks that bailed out the market.  Beijing needs to sell off its purchases but right now it’s the only player in the market forcing it to negotiate with itself.

Beijing stabilized the market.  Now it has to deal with the unwanted lizards, snakes, and gorillas.



Are We Witnessing a Giant Debt for Equity Swap?

A working theory by Chinese and foreign observers of the Chinese stock market run up has posited that listed companies are using this time to issue new equity buying out old debt and reducing leverage.  While this is an attractive theory, the data does not support the idea that this is taking place.

If we begin with broad market data on IPO and SEO offerings, we see that many firms are rushing to markets with IPOs.  In the past years, IPO’s have averaged about 25 per month in China but these have typically been relatively small IPOs with an average of 547 million RMB raised per IPO.  By Chinese standards, this is virtually irrelevant from a macro-financial perspective.

If we focus on SEO offerings, there has been an increase the number of firms with secondary offerings and an increase in the amount of total capital raised, but has been nothing like the flood being discussed.  For instance, the number of firms having SEO offerings appears structurally higher but only moderately higher, with lots of month to month fluctuations, and total capital raised reflecting similar patterns.  Total monthly capital raised in the first 5 months of this year averaged 69 billion rmb which a higher than the average 51 billion rmb raised during the same time frame in 2014, but not exactly what one would call a flood.  Furthermore, the average value of capital raised per firm declined from 1.65 billion rmb to 1.46 billion rmb.  While these are not completely insignificant sums of money, 69 billion rmb in equity raised monthly  in a capital market the size of China is virtually irrelevant and does not represent a flood of companies seeking to swap debt for equity.

If we break it down further to look at individual offerings and location, we see a similar pattern.  For instance, since the beginning of 2014, approximately 60% of new stock offerings have been offered by Shenzhen listed firms rather than Shanghai listed firms (180 to 115 to be precise).  Given the differences in types of firms, this results in significant differences in offering size.  The average secondary offering  size since the beginning of 2014 has been  364 million rmb in Shenzhen and 814 million rmb in Shanghai.  As noted in the previous post, given that most firms in Shenzhen are not what would be considered key firms and that most of them are many magnitudes smaller than their state owned competitors, this tells us that while smaller and private firms may be trying to raise new capital, there is scant evidence to support the idea that a macro-financial debt for equity swap is taking place.

There is one final points that makes the behavior of firms and regulators interesting in China.  While firms are typically motivated to obtain the highest price possible for the equity and investors typically see new share issuance as a negative sign, the complete opposite appears to happen in China, at least in the past 18 months.  For instance, the average stock price gain 5, 10, and 20 days after issuance on new stock was 117%, 184%, and 207%.  In one famous case, a post-IPO Shenzhen tech firm gained the maximum 10% every day after debuting for a number of months.  Three, six, and 12 month gains witnessed a flattening and then large declines based upon the original offer price with gains of 232%, 220%, and then 109% from original offer price respectively.  This implies that investors, initially caught up in the euphoria of a new stock offering bid it up rapidly until it peaks approximately 3-6 months after the original issuance, at which point reality sets in and a long term decline begins which still leave original investors better off than the original offer price but having lost a lot from the peak.  Given high average turnover rates however, it is unlikely that original investors remain invested in the stock.

Whereas firms and IBs in most developed markets are free to set equity offering prices pretty much at whatever they deem fair, Chinese regulators assume a much stronger role in initial price determination.  The average PE of newly issued stock is 22.6 with a standard deviation of 5.3.  In Shenzhen those numbers are 23.2 and 5.9 respectively while they are 21.7 and 4.1 in Shanghai.  On a broad market basis, regulators seem to be under pricing new share offerings in Shenzhen but overpricing them in Shanghai.  In fact of equity issued since the beginning of 2014, which is somewhat biased due to the recent stock increase, 6 months after issuance, Shanghai offerings are up 288% compared to 1,407% compared to Shenzhen.  There is no known clear reason why firms are essentially required to forgo lots of capital in order to under price their share offerings.  Furthermore, if the regulator was pushing firms to delever by swapping it for equity, this is a very expensive way to pursue this strategy by significantly under pricing the shares on offer.

It is incredibly tempting to try and read rational motives into the behavior of regulators, investors, and firms.  One theory on offer is that the stock market run up is allowing heavily indebted firms to delever by selling equity to buy out debt.  However, there is little evidence of this happening and definitely not in amounts necessary to reduce corporate debt levels or by the major companies in China.  While Chinese stocks may not be as overvalued as a whole as some believe, firms definitely are not using this time to delever by any significant degree.

Note:  Here is the data used in this analysis from WIND