The sky over Shanghai is yellow. Observations about the Chinese Equity Crisis

Preface

During these past few months, I’ve had courtside seats to the circus the Chinese equity market has been putting on. Working as a summer intern at a private equity firm out of Shanghai’s financial district, I’ve had the opportunity to learn from some very smart people and hear what they have to say. This post is some of what I’ve gathered from the aforementioned and watching market movements during lulls in my workday.

Disclaimer:
I am an undergraduate student, so this should be taken with enough salt to make the fish float in Lake Michigan. Most of statements about the way the Chinese economy works are gathered from personal accounts of native businessmen and politicians, not hard data.

TL;DR: China isn’t the US, and you can’t look at it like you would the US.

One thing I’ve noticed about the coverage of this lesson in tick-chart physics is that the writers often frame this crisis in terms of past events that took place in the United States. They assume that the sky over Shanghai and Shenzhen is the same shade of blue as it is in New York. It’s not; currently Shanghai has a nice muddy-brown yellow color going. They’re completely right in that the stock market is behaving as it did during the tech bubble of the early 2000’s and that the real estate market is mimicking market behavior prior to the Great Recession, but when they assume what happens next will follow the same rules we follow in traditional capitalist countries like America.

1. My accounting classes are useless here.

During my first three weeks here, I didn’t touch a balance sheet once. Nada. My boss pretended not to know what fundamental analysis was. Whenever I mentioned that I was studying accounting at school, people smiled the same, knowing smile. It took me a while to realize it was the same smile children get when they bring up Santa Claus, or the tooth fairy. We sometimes forget that the advent of the accounting as a critical part of financial analysis has much to do with regulatory legislation like Sarbanes-Oxley. If the People’s Republic has such laws, they certainly aren’t enforced. I don’t know if public Chinese companies even bother to doctor their books; the public could care less if they’ve switched from FIFO to LIFO within the past year. The amount of aggressive margin trading present in the Chinese retail investor base should be proof enough; the Mandarin words for “debt-to-equity ratio” have as much meaning to them as the Easter bunny does to us. Technical analysis is in fashion here, and there’s a reason why.

(Source: TMT VP at PE firm, Senior fund manager at a multinational corporation)

2. There’s a good reason why technical analysis is the flavor of the era here.

In ancient China, the emperor was only the emperor if the people believed he had the “mandate of heaven”. Today, it seems that the people here still pick stocks along the same criteria, except the “gods” take the form of the Chinese Communist Party, sometimes more literally than you might think. As a people with a healthy fear of our government, we Americans can’t seem to comprehend this concept of an almost omnipotent government. (Currently, we’re in a state of denial that our government is omnipresent.) It’s the lack of this deep-set fear of a power imbalance that allows the government of China to have its cake and eat it too—this is capitalism on the terms of China’s ruling oligarchy.

Fundamental analysis is, in the states, a primary tool in the search for α, alpha; true business value that translates to capital gains beyond the benchmark. It’s no secret that government-sponsored market manipulation takes place in PR China, but there is no outrage—no one is trying to occupy Lujiazui or calling for government reform. The Chinese people have thousands of years of practice with imperial power; they know that going with the current is more profitable than fighting the riptide. What good are a widening gross margin and consistent growth in EBITDA next to the backing of the money-printing gods? In a fantastical land where PE ratios hit the thousand’s and nobody blinks, there’s logic in the pursuit of the illogical. And that’s technical analysis—armies of hedge fund analysts sitting before their magic charts, scrying through the candles and ticks in a hunt for the mandate of heaven, Malkiel and Buffett be damned.

(Source: a woman who admitted to worshipping the Party, a Communist party member, a local journalist covering the financial markets)

3. The Chinese government can move more quietly and efficiently than ours.

When we think of government intervention, we think of Abrams tanks rolling on Sarajevo, the Treasury Department mustering billions for the TARP, maybe the creation of a new regulatory bureaucracy. Take the government response to 2008, for example. Highly public, and therefore highly controversial: politicized beyond a PR department’s wildest nightmare, clumsy, arguably too little, too late, especially if you worked for Lehman Brothers. The People’s Republic of China moves through different channels. While they may pursue traditional means of monetary policy through interest rates and Treasury , China relies primarily on more direct action—capital injections into the public equity markets. This is accomplished through China’s state-owned businesses, which form the core of China’s economy—the government will channel funds, directly purchasing equity to backstop capital markets. Through huge equity investments in three industries—banks, insurance companies, and non-bank financial firms, the Communist Party has and will cushion the fall of stock, trigger a reversal in pack movement from the Chinese retail investor base, and gradually liquidate its investment once equity share prices reach higher levels, possibly earning a profit. This very well might be the world’s biggest pump-and-dump scheme.

Evidence of this type of market manipulation can be found publicly—for example, on July 9th, the day of a huge market rally, trading volume across Chinese A and B shares was led by government-owned and -run banks Bank of China, Industrial Commercial Bank of China, and Agricultural Bank of China, followed by Chinese gasoline monopolist Sinopec. Not only was the Party discouraging of shorting, they were willing to pull the trigger and ban it and hedge fund redemptions—fast responses that would have taken our government at least days of discussion first. In addition, the Chinese government maintains a syndicate of “private” hedge funds—owned by influential Communist Party members with party funds. The 120bn RMB investment announced on July 5th very well could have been much larger due to the existence and activity of this syndicate. In 2008, Fed and Treasury staffers worried over what type of precedent would be set by a government-bailout. Here in China, government officials worry over what type of precedent would be set by the lack of a government-bailout.

The idea of the Chinese government losing control over its economy is to the Chinese investor as ludicrous as the idea of the American government losing control over its military. We talk about how bad the Chinese housing bubble is, but ultimately, the Chinese government decides where house prices go, and everyone I’ve spoken to agrees they won’t go down. Sure, maybe they’ll drop a little, but they won’t crash. In addition, housing simply doesn’t have the strings to orchestrate a market collapse a la 2008. Then, mortgages were a billion dollar industry, so intertwined with the rest of the financial services and thus the rest of the economy that everything rose and fell together. China’s housing industry, though bloated and inflated, is very different. For one, down payment requirements are higher--around 20% for the first home, and higher for the second. The idea of losing your house to foreclosure is the very height of shame for Chinese yuppies, who often still live with or around their parents. With a few exceptions, Chinese residential and commercial mortgages are barely securitized at all, not next to the elephant in the Situation Room in 2007. China isn’t America, and you simply can’t view the two through the same lens.

Which leads to an interesting question. If the Chinese government is so powerful, why is this crash even happening?

(Source: a Communist party member, a hedge fund manager, a different Communist party member, a local journalist covering the financial markets, corporate executive for multinational corporation)

4. This equity crash might not hurt the Chinese government at all.

Among the people I spoke with, there seemed to be one consensus. No one had their money in equities. Sure, some of my sources would throw a few blocks around to ride the surges they knew were coming, but none of them would ever leave their money in for more than a few days. The smart money has left the market, leaving the less well-informed locked-in with aforementioned bans. But hit hardest are those China’s retail investors who chose to dabble in leverage—mostly young people in the early 20’s to late 30’s in white-collar professions. But despite the flight from equities in the higher echelons of wealth, the Chinese government still continues to release optimistic market guidance. Could it be that the fall of the markets serves a purpose for the government?

There’s a number of conspiracy theories making its way through the Chinese retail investor base that this market crash was allowed to happen by party leadership. Normally, as Americans with a government dependent on election cycles, we dismiss these ideas as nonsense and paranoia. But this is China, a land with thousands of years of intrigue behind it. There are several good reasons for the Chinese government to let markets drop. First, the Chinese retail investor learns about risk and leverage the hard way—to teach the laobaixing that the Chinese equity market is a gold mine with shoddy scaffolding and only the government has a map. Second, to deal with China’s biggest domestic problem right now—the growing exodus of the afore-mentioned white collar professionals in their 20’s and 30’s. This exit of the nation’s youth has been of much concern to senior officials; China’s best and brightest seem to be leaving the country the moment they accumulate sufficient economic means. The fall in equities not only postpones their exit timeline, but also locks in their funds as investors heed the positive market guidance propagated by government media sources. Third, China’s stock market is seen to behave like a traditional free market, with downside to complement its extraordinary growth, where the invisible hand influencing valuation is the market itself, not the government. Unable to silence its Wall Street critics and desirous of foreign investment to propel China’s rise to consumer economy status, the government has let the market drop amid positive government statements to disguise its ability to control and manipulate the equity markets. Fourth, the government seeks both to reconsolidate its own treasury positions in China’s largest corporations by buying stock at the new fallen values.

(All of this is wild conjecture. But they believe it here, so I thought to include it.)

But who can really know why the Communist Party chose to let markets crash? Maybe the insiders were told the play of the year was put options. Maybe Xi Jinping wanted to see a few dead cats bounce. All I can tell you solidly is that the party members I’ve spoken with had their money out of A-shares and in more stable asset classes—say, American residential real estate. Tell your new neighbors ni-hao for me.

(Source: private equity VP, Communist party members, local journalists, hedge fund manager)

5. The US should be scared of China, but not of its military.

China is currently undergoing a transition it hopes will turn it from the most prominent of the world’s emerging markets into a major player on the first-world stage. The government is trying to transform China from the place where your toys were made cheaply into a place where people dream of living. It’s no question that China has ambitions of empire, but the question the American people have worried over is how China plans to achieve these goals—Yahoo.com today (July 30th, 2015 at 0630 EST) shared ten articles on its homepage that focused on China, of which three looked at China’s military and possible scenarios involving China’s military. While China has indeed ramped up its defense spending, there is no sign from the people I talked to that China has a desire to pursue expansion militarily—defense spending may be simply a prop to its flagging manufacturing economy.

In fact, the last thing China could want is a war with the United States, be it hot, or cold. From early attempts by Mao to foster friendly relations with the US, China has always had a fascination for American culture, a desire to emulate and assimilate that displays itself in Chinese modern culture today. Young people watch American hit shows like Game of Thrones and House of Cards, wear Nike and Forever 21, and eat at McDonald’s and KFC. When you go look at phones and electronics, the store assistant will be the first to inform you that “this is what they use in America” (usually false). China directly going to war with the US would be as unimaginable as declaring war on Santa Claus and the tooth fairy.

What the United States should be wary of is China’s desire to establish an economic empire, exerting influence through trade. China is rapidly expanding its interests in Africa, attracted by the promise of natural resources and untapped consumer markets. By establishing both a relatively large expatriate population and business relationships through loans from its giant state-run banking syndicate, China has positioned itself optimally to benefit from the economic maturing of the African continent. Just as China has benefited from American foreign policy in the Middle East by entering markets inaccessible to American companies, they hope to take advantage of America’s natural risk aversion to Africa to secure the first-mover advantage in the continent. Also, China's central bank has a first priority of replacing the US Dollar with the Renminbi Yuan as the global currency. In this arena, our worst enemies aren’t the ones shouting “Death to America” in the streets but the ones wearing our brands driving our cars. (Funnily enough, Dickie’s, the discount slacks brand, is considered high luxury here.)

(Source: everyone else previously cited.)

I think the biggest takeaway from this is that nothing in China can be taken at face value, be it accounting information, government-sponsored market guidance, or street food advertised as "chicken" kebab. China’s current governing body has always been able to twist foreign ideologies to fit their own purposes: socialism, to start with, and now capitalism. As for the capital markets, the only solid promise they carry are volatility and the government’s artificial inflation. From all of what I've learned, the only conclusion I can draw personally is that the Chinese stock market is simply another government-owned business. The only people who should be playing at a rigged card game are the people who rigged it. I’ve been watching China’s markets and the only stocks I can recommend are government-owned blue-chips, in the financial sector especially. If you can’t beat them, join them.

Again, I’m an undergraduate student, and I probably don’t know what I’m talking about. If you guys are interested in hearing about the details of my PE internship in Shanghai, hit me with a PM and if there’s sufficient interest, I'd be happy to do a Q&A.