The Cost Of China's "Manipulated Market Stability" May Be Too High, BofAML Warns

In August, we learned that even spending CNY1 trillion in plunge protection to prop up an equity market reeling from the unwind of a bevy of backdoor margin lending channels was woefully insufficient. The reason (or one of the reasons): the millions of semi-literate retail investors, housewives, and farmers that had poured money into the market and had previously been inclined to buy every last dip were suddenly selling every last rip in a desperate attempt to recoup their savings which had just been vaporized before their very eyes. 

Ultimately, once Beijing had tried halting three quarters of the market and then throwing more than a trillion yuan at the “problem”, Chinese authorities just started arresting people. First short-sellers, then brokers, then journalists, and finally, just plain old sellers. 

True, that’s not good for China’s international reputation from a kind of human rights/freedom of speech perspective, but when it comes to showing the world that you’re committed to liberalizing capital markets, it sure beats effectively nationalizing a whole collection of equities and halting 75% of trading. Not to mention the fact that when you’re trying to execute a “controlled” currency deval on your own terms and there’s already quite a bit of downward pressure, it’s not entirely clear that you want to be printing too many more trillions of yuan. 

Of course even though China may have succeeded in “arresting” some of the pressure with its “kill the chicken to scare the monkey” witch hunt and thereby might possibly have avoided having to dump still more money into buying shares, to a certain extent the reputational damage was done from June-July when CSRC bought some CNY900 billion in shares. As we’ve put it before, that falls outside the bounds of manipulated market decorum even in a world that’s used to central banks providing plunge protection. 

On Friday, BofA’s David Cui is out with a look back at China’s Q3 plunge protection and a look forward at what the numbers mean for the effort’s future. 

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From BofA

Largely based on top-10 shareholder information disclosed by A-share companies, we estimate that the government likely spent at least Rmb1.5tr in Q3 to support the market (Table 1). Given the potential damage to the PBoC’s and RMB’s reputation, economic growth and long-term financial system stability, we think it unlikely that the government has the resolve to keep buying if heavy selling pressure in the A-share market resumes at certain point. 

The prices paid so far 

Excluding ETF positions, the government and affiliated funds bought shares in at least 1,365 A-share companies in 3Q, representing 49% of the total number of A-shares and roughly 7% of the A-share market’s free float. Of this, by number of stocks, 58% are listed on the Main Boards, 26% on SME and 16% on GEM (Table 2); by market value, close to 90% is on the Main Boards, 7% SME and 3% on GEM (Table 3); by market cap in value, about 60% are in stocks with Rmb50bn+ market cap (Table 4); by sectors in value, some 40% are in financials and 20% in industries (Table 5); by trailing 12-month PE, about 30% is at 40x+ or loss-making and 20% at is 20-40x (Table 6); by yield, about half is at 0-1% (Table 7). We estimate that the government’s position, including ETFs, incurred a Rmb220bn loss as of Sept 30, but the loss had turned into a small gain by Nov 11, after the recent market rebound (Table 1). 

The unintended consequences Leaving aside damage to its reform credentials, the government’s stock-buying program may negatively impact the economy and financial system: few central or commercial banks lend money to fund stock purchases, especially at this expensive valuation – this cannot be enhancing investor confidence in RMB; the related lending had contributed to an acceleration in M2 growth (13.5% YoY in Oct vs. 6.2% nominal GDP growth in 3Q); this excessive liquidity appears to be rushing into the tier-1 city housing market and the bond market.

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Right, so nothing particularly new in the first few sentences there. China will be unwilling to continue the plunge protection because, i) it damages their reputation in terms of liberalizing capital markets, ii) printing trillions of yuan in the middle of an uncertain FX enviornment is probaby not the best idea, especially when you're trying to "control" the deval, iii) there are potentially dangerous spillover effects into other "assets."

What is interesting is that CSRC had incurred a CNY200 billion loss as of the end of September. Although that loss appears to have been recouped, that speaks to the potential for disaster here should the A-share market take another turn for the worst. Consider one more table which shows that nearly a quarter of the national team's massive portfolio was purchased at a PE of 40 or greater:

Which brings us to BofA's conclusion: 

Selling pressure likely to resume This is because the A-share market is expensive and leverage in the market is still high.

 

Ex. banks, the A-share market is trading at 32.4x trailing 12-month earnings. On leverage, we estimate that approximately Rmb8.9tr market value, including all the government’s positions, is either partially funded by borrowing or pledged for lending (Table 8). This is equivalent to around 43% of the A-share market’s free float. Given the high financing cost of these positions and the expensive valuation, we suspect that it could be a matter of time before heavy selling resumes.

In other words, the CNY220 billion paper loss the CSRC was staring down at the end of September could end up looking small by comparison should things take a turn for the worst given valuations and given the amount of leverage still built into the market.

Should massive losses materialize, we imagine the Politburo will be arresting a lot more Yao Gangs and other CSRC officials for "graft"...