Fra Bank of America
The A-share correction: The damage could spread far beyond the stock market
A dent to market’s faith in government role
We believe that the biggest damage caused by the A-share market’s roller-coaster ride since the middle of last year has been to investors’ faith in the government’s ability to manage asset prices (stock, RMB, debt and even property) reasonably smoothly. The difficulty the government has faced to stabilize the stock market has demonstrated the downside of that faith. As a result, we expect many of these assets to be re-priced lower going forward. Also,the ripple effect from the market correction has yet to show up – we expect slower growth, poorer corporate earnings, and a higher risk of a financial crisis.
Many assets in China may get re-priced lower
We question the implementation of government policy in urging people to buy stocks. Regarding the deleveraging process in the market, in our view the government started too late & without adequate preparation for the potential downside (we suspect because it didn’t know the true extent of shadow margin financing activities) and it resorted to administrative control when the market turned down. So far, government measures have appeared to us to be behind the curve. As a result, we expect investors to assign less value to various perceived government “puts” going forward. The fall in the stock market could also make the government even more cautious towards QE and potentially using the property market or debt market to hold up growth, in our view – a burst of any of these bubbles, if fully developed, will be far more difficult to deal with than what’s happening in the stock market.
Real economy & corporate earnings will suffer
The net result of this volatile market is a transfer of wealth from the people on the street to the wealthy, including many major shareholders, who cashed out. We expect this will likely hurt consumption down the road. More critical is a potential distortion to credit flows due to the impairment to financial institutions’ balance sheets – as experience with Japanese banks shows, even if they don’t have to mark to market and book losses, their lending attitude may turn more cautious. Of course, the impact of a full-blown financial crisis in China, if it materializes, on the economy would likely be severe. On corporate earnings, other than the drag from slower growth, many companies may have to book stock-market related losses over the next few quarters by our assessment.
A possible trigger for a financial crisis in China
If the market continues to fall sharply, stock lending related losses could run into Rmb trillions, of which, banks and brokers may have to bear a meaningful share. These potential losses can be especially dangerous to brokers whose capital base is less than Rmb1tr. Even more important, the opaqueness of China’s financial system and the lack of clear definition of risk responsibility mean that contagion risk is high, similar to the subprime crisis. We had always considered the risk of a financial crisis in China as high. What has happened in the stock market has likely increased the risks considerably and also brought forward the timeline by our assessment – the leverage is much higher now and economic growth rate, potentially lower.
We’ll leave you with following chart from Morgan Stanley which should be enough to dispel the notion that the deleveraging in China might have run its course:
