At the time of writing, CSI 300 was down by more than 20% from its peak on 24 January 2018, while the S&P500 was only down 4% from its peak on 26 January. The trigger for the turn in the A-shares’ fortune was a combination of a slowdown in domestic growth momentum, when weak economic data started flowing in May, and a rise in Sino-US trade tensions, though we have been expecting the growth slowdown since April. The market just piled this onto the prevailing worries about deleveraging, defaults and liquidity squeeze.
While the probability for a full-blown trade war (with China retaliating on Trump’s tariffs on all Chinese exports to the US) remains low at this point, at around 10% in my view, the probability of a resolution is probably even lower. This means that there is more than 80% probability for long drawn-out negotiations to keep Chinese stocks apprehensive/volatile.
Fears rise as growth momentum weakens further
Since May, credit growth and macroeconomic indicators have weakened further from an already soft trend, reflecting a self-inflicted slowdown by Beijing’s deleveraging policy that has hit shadow banking especially hard. The impact of the contraction in shadow financing has fallen largely on the private sector and, thus, hurting “animal spirit” (or private investment incentive) and market sentiment badly.
Credit spread has widened and corporate defaults have risen, though in absolute terms the number remains small. According to the PBoC, about RMB66 billion worth of corporate bonds, or 0.4% of the bond market cap, had defaulted on coupon payments in 1H 2018. But the trend of rising defaults is creating jitters about declining credit growth creating an upward default spiral.
Fears have also been heightened by the increase in the so-called pledged lending. Since 2016, many major shareholders in listed companies have pledged an estimated RMB5 trillion worth of their A-share holdings (or 10% of the A-share market cap) as collateral for bank loans. In a market sell-off, the banks would issue margin calls. They would start selling the shares collateral if the borrowers cannot meet those calls, thus risking a downward spiral in the stock market. And if liquidity were to dry up, massive suspensions would result and repeat the nightmare of the 2015 market crash.
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