A Bitter End To The Year Of The Snake

The author is Capital Economics’ China economist Qinwei Wang

The weakness in China’s stocks has continued into 2014. The Shanghai Composite
index lost 3.9% this month, following December’s fall of 4.7%. But China’s
equity markets have at least escaped the recent sell-off in emerging market assets, which has hit other emerging Asian equity markets, including Hong Kong.

This once again reflects the fact that China’s capital controls and the limited participation of foreign investors largely insulate the country’s financial markets from swings in global investor sentiment.

The weakness in Chinese equities has largely reflected domestic factors. There have been increasing concerns about the state of the economy. Continued downbeat data releases, including the recent sharp fall in the HSBC/Markit manufacturing PMI for January, suggest that the momentum in the economy is still fading.

Meanwhile, although the troubled "Credit Equals Gold No. 1″ trust product was
rescued at the last minute, it has raised worries about the health of China’s shadow banking sector.

The country’s securities regulator allowed IPOs to resume this month after a
moratorium since late 2012, with new efforts to simplify approval processes and
increase the market’s role in initial pricing.

But such measures appear to have done little to boost investor confidence about the outlook for the equity market. There are also other structural problems, such as lack of transparency in the disclosure of information.

Indeed, relative to earnings, Shanghai equity prices have reached a new low, with the trailing Price/Earning (PE) ratio falling below that of Hong Kong. The P/E ratio has continued to run below the equivalent for the S&P 500 and the gap has widened further.

Liquidity squeezes appear to be another factor behind the poor performance of stocks. The People’s Bank of China has kept monetary conditions tight in order to slow credit growth, which has made short-lived cash crunches more frequent.

Interbank rates surged again in the second half of this month. The trigger was probably linked to the seasonal strength in cash demand ahead of Chinese New Year.

However, the PBoC appears to have done a better job to calm investors than in June and December. It quickly resumed its money-injecting market operations and expanded its Standing Lending Facility (SLF) to include smaller, typically liquidity constrained banks.

Policymakers appear to be happy with the current level of market rates – the PBoC
stalled its regular liquidity-injecting operations again late this week. The medium-term objective remains to keep monetary conditions fairly tight.

As a result, onshore government bond yields remain relatively high. With fears about another cash crunch easing though, short-term government bond yields have fallen somewhat.

Finally, the RMB has been trading around 6.05 per U.S. dollar over the last few weeks, following a short-lived gain at the end of last year.

Intervention by the PBoC continues to prevent the currency from appreciating. The RMB is worth more offshore. This gap is likely to close soon, given the ability of firms with cross-border trade operations to arbitrage any difference.

(The article has been edited for clarity)

China Expert network