The pros and cons of a bull market
In sharp contrast to their approach in 2007, Chinese government officials are actively encouraging the current bull market in onshore equities, repeatedly saying that rising share prices are a good thing for China. We agree that there are definite economic advantages to the runup in stocks, but it is also worth keeping an eye on the risks.
The most direct benefit of the bull market is that it has already lifted China’s economic growth rate. While the official year-on-year growth rate of China’s gross domestic product slowed to 7% in the first quarter, tertiary industries grew at a relatively robust 7.9% pace. Most remarkably, the growth of the financial services sector accelerated to 15%.
At slightly less than 10% of GDP, the financial sector has typically accounted for 0.6-0.8pp of real GDP growth in recent years. By our estimates, that contribution doubled to 1.4pp in the first quarter of 2015, largely because the bull market fueled higher earnings at non-bank financials such as brokerages. Without the run-up in stocks, it is unlikely the economy would have hit Beijing’s growth target (the jump in the finance sector’s contribution to growth also helps explain why correlations between GDP growth and other economic indicators broke down in 1Q).
There is also a potential benefit from the wealth effect. In theory, when the value of household assets goes up, consumers feel wealthier and spend more. But in aggregate Chinese households have only limited exposure to the equity market. Our best estimate is that retail investor stock holdings are worth about RMB 13 trln. In comparison, wealth-management products are worth some RMB 15 trln, while household bank deposits amount to RMB 54 trln. However, by far the biggest household asset is housing. We estimate the urban housing stock is worth about RMB 149 trln at current market prices.
This implies that households hold only around 5% of their total assets in the stock market. Since there was little evidence of a wealth effect on consumption during the long upswing in housing prices, we doubt whether the relatively small increase in household assets caused by the equity bull market will have a noticeable impact.
The economic benefit that has been talked about most— including by People’s Bank of China governor Zhou Xiaochuan—is the effect of the bull market on equity capital markets. Company valuations improve in a rising market, and both IPOs and secondary placements get much easier. As a result, corporate debt/equity ratios fall and the economy becomes—or should become—less dependent on debt financing, which moderates overall economic risk. A bull market will also allow Beijing to sell the shares of stateowned enterprises at higher prices, much as it did in 2007, which should facilitate SOE reform.
The equity capital market activity has indeed picked up since 2014. The amount of capital raised has risen for five quarters in a row as the regulators have given the green light to more deals as the market has climbed. Despite the recent increase, however, equity financing remains relatively small, at less than 5% of total social financing, compared with 20% at its peak in 2007. What’s more, most of the companies offering new shares today are private firms whose balance sheets are generally in good shape. For equity financing to have a meaningful impact on the wider economy, far more companies—and more heavily-indebted companies—will have to come to the market.
Of course, while a bull market in stocks is welcome, not all the implications are positive. The most obvious risk is the effect of rising margin debt. From RMB 400 bln a year ago, total margin debt has quadrupled to RMB 1.8 trln, equal to some 3% of today’s equity market capitalisation. To fund their loans to stock investors, brokers have borrowed from the interbank market. If the stock market suddenly reverses and investors default on their margin debts, the contagion effect will be much greater than in previous cycles, since the banking system is now more exposed to the brokerage industry. If any brokers get into trouble, banks may end up taking losses as well.
A secondary but nonetheless significant risk is that the combination of a slowing economy and a rising equity market may encourage companies to divert capital into stock market speculation. As the economy has slowed, corporate earnings have deteriorated, especially in heavy industrial sectors. With companies struggling to make money from their core businesses, investment gains from a rising equity market will account for a greater share of total profits, potentially prompting companies to increase their exposure to the stock market. Consequently corporate profits will become even more dependent on the stock market, increasing the volatility of earnings. If market’s trend reverses and the economy remains weak, earnings will suffer a double blow.