China Government Agencies Bought Stock While Regulator Cracks Down on Brokerages

by the Curmudgeon with Victor Sperandeo

Introduction:

Victor has written extensively that China's stock market had been rising earlier this year, even as its economy was tanking. He also noted that the IMF's rumored decision to include the Yuan/Renminbi in its Special Drawing Rights (SDR) basket of currencies¹ propped up global stock markets this September as more money would be going into Yuan/Renminbi denominated equities.

Note 1. The IMF executive board is expected to make its decision on November 30^th. The Renminbi will be included in the new SDR basket of currencies on October 1, 2016, joining the dollar, euro, yen and pound sterling.

However, there's another reason for the 28% rally in China's Shanghai Composite stock market off the late August lows. It was Chinese government financial entities buying equities to prop up China's stock markets.

China’s ‘National Team’ in Action:

On August 27^th, Bloomberg reported “China Intervened Today to Shore Up Stocks Ahead of Military Parade.” The article stated that “China’s government resumed its intervention in the stock market on Thursday and has been cutting holdings of U.S. Treasuries this month to support the yuan, according to people familiar with the matter. Authorities want to stabilize equities before a September 3^rd military parade celebrating the 70th anniversary of the World War II victory over Japan, said two of the people, who asked not to be identified because the move wasn’t publicly announced.”

According to an analysis by Goldman Sachs, China has spent $236 billion (1.5 trillion Yuan) on its stock market bailout. The numbers underscore the high cost of Beijing's efforts to prop up stocks - a response that has been panned by some critics as unnecessary and counterproductive.

Now, the details of the China government's stock buying campaign have been revealed for the first time. The November 27^th Financial Times (FT) – on line subscription required – reports that “a group of Chinese state-owned financial institutions owns at least 6 per cent of the mainland stock market as a result of the massive Beijing-sponsored rescue effort this year to prop up share prices following the summer equity market crash.”

· China Securities Finance Corp (CSF), the main conduit for the injection of government funds, owned 742 different stocks at the end of September, up from two at the end of June. The market value of CSF’s holdings increased from only Rmb 692m ($108m) at the end of June to Rmb 616bn three months later.

· Central Huijin Investment, the holding company for shares in state-owned financial groups and a subsidiary of China’s sovereign wealth fund, also bought shares. The market value of Central Huijin's holdings fell by Rmb 167bn in the third quarter to Rmb 2tn, mostly reflecting mark-to-market losses on shares it previously held. That decrease in market value came despite Huijin’s additional share purchases in the period.

CSF and Central Huijin were the largest of a number of government rescue funds that were ordered to buy shares when China's stock markets went into a nosedive over the summer. The Shanghai Composite index fell more than 40 per cent from its seven-year high on June 12 to its late August low.

These two state financial institutions that led the bailout increased their ownership of the Shanghai and Shenzhen exchanges from 4.6 per cent of total tradeable A-share market capitalization at the end of June to 5.6 per cent three months later, according to Wind Info (a financial data services company in China).

The FT said “the figures were compiled from the quarterly statements of listed companies, which are required to disclose their 10 largest shareholders. The actual size of national team holdings is probably larger, given some probably hold stakes that are too small to rank in the top 10.”

In a November 26^th article, International Business Times reports that “China Stock Market Regulator Is Investigating Country’s Largest Stockbrokers For Irregularities.” The article states that there were injections of hundreds of billions of dollars to prop up China's stock market this summer.

“The government intervention in China’s mainland capital markets appears to have worked, at least for now: The Shanghai Stock Exchange Composite Index has risen more than 25 percent since mid-August.”

The FT article noted that the significant role of the China national team in propping up the domestic stock market has raised concerns about the sustainability of the recent share rally and about what would happen to the market if the government unwound its holdings. The IMF has urged Beijing to quickly unwind its massive state intervention to support falling share prices, and warned that the true risk would come from slowing reform.

The Chinese securities regulator (see Late Update below) this week rescinded a ban on stock sales by brokers' proprietary trading units, according to leaked documents published by local media. The brokerage industry association said the group of 21 would not sell their holdings until the Shanghai Composite reached 4,500. It closed at 3,648 on Wednesday.

Fundamentals also indicate that China's recent stock market rally may not be justified. Earnings at Chinese A-share companies fell 16% annually in the 3^rd quarter, including a 37% drop for non-financial companies, the worst quarter since 2010, according to Credit Suisse.

However, that's also true for the U.S. stock market where corporate earnings have fallen for two consecutive quarters and are not likely to recover in the current quarter, as the Wall Street Journal and numerous other publications have pointed out recently.

Victor's Closing Comments:

One must never forget China is a communist country. Although they have had to mix some capitalism into communism in order to feed 1.4 billion people they control virtually everything. As all communist countries have shown, this type of controlled social system always fails. The USSR is the greatest example of failure. For the reasons why -please read "The Road to Serfdom” by Friedrich Hayek or "Human Action," by Ludwig von Mises.

Also, China's DEBT IS MASSIVE, according to The Economist magazine.

"This means that China's overall debt-to-GDP ratio is continuing its steady upward march (see chart below). Debt was about 160% of annual output in 2007. Now, China's debt ratio stands at more than 240%, or 161 trillion yuan ($25 trillion).”

Forbes magazine says it's higher! As of May 5th 2015, China's debt to GDP ratio was 280%, according to Forbes.

However, China's actual debt and debt to GDP ratio is really unknown, because China's economic numbers can't be trusted by professionals who don't believe them to be accurate.

This is the scary part of China having a hard landing recession. Like most of the world, huge debt and zero or very low interest rates create a potential “end of days” like scenario when interest rates rise (as they usually do during a real economic expansion).

This is why owning stocks to help keep markets up is a no win game in the long run, but makes governments feel good in the short run.

Like all "games" that governments play they can't control all events. The most common surprise reason interest rates rise is war. Like the recent Turkey shoot (no pun intended) of a Russian fighter jet that briefly flew over Turkey's air space.

Accidents and unknown problems can and do occur. As the old saying goes, when manipulators try to artificially prop up stocks and then want to sell, the question is always to who? Will everyone find a chair when the music stops?

Late Update: China stocks fall sharply on regulatory crackdown

The Shanghai Composite index dropped 5.5% on Friday, November 27^th, marking its biggest drop since August. The rise in the Shanghai Composite Index since late August along with Friday's sharp decline is illustrated in the chart below, courtesy of Big Charts.com:

Late on Thursday, it was announced that China's securities regulator was investigating the country's largest brokerage, Citic Securities. The firm is being probed over the possible breaking of market rules. Rival brokerage Guosen Securities is also being investigated, and shares in both Citic and Guosen fell by 10%, the maximum allowed in one day. In addition, trading in China Haitong Securities shares was halted and later in the day the firm also confirmed it was under investigation.

Good luck and till next time...

The Curmudgeon
ajwdct@sbumail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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