The Root of China’s Potential Bubble

Earlier this year, the People’s Bank of China began an all-out monetary easing campaign designed to help boost its economic growth. These dynamics – combined with looser margin requirements for traders and glowing state media reports – caused the Shanghai Stock Exchange Composite Index to nearly double in value over the 52-week period leading up to mid-June when the market experienced a day of reckoning (see Figure 1 below).

Domestic and international investors became spooked and the market plunged 30% in just three weeks – a dramatic decline by almost anyone’s measure.

In an effort to curb the decline, the central government introduced an unprecedented rescue package that banned insiders owning more than 5% of a stock from selling shares, banned short-sellers with the threat of prosecution, halted any new initial public offerings to constrict supply, opened the doors for the government to invest directly in the market, and made it easier for traders to buy on margin, among other things.

But, why did the government rescue the stock market? After all, the Chinese stock market represents just 40% of its gross domestic product, compared to more than 100% for most developed countries, according to The Economist. The answer is because it’s concerned about the rest of the restructuring that needs to occur within its economy, which requires both capital provided by the markets and confidence among individuals that own some 90% of the market.

The good news is that the effects of these policies were both predictable and immediate, with a quick rebound in equity prices, but experts agree that these are only temporary solutions to a long-term problem with the country’s slowing economic growth. Since 2008, the country’s gross domestic product growth has slowed from nearly 14.5% to less than 8%, while equity markets have made a remarkable turnaround since mid-2014 (see Figure 2 below).

The governments monetary easing policies have been largely ineffective, because they fail to address the root cause of the problem. After the 2008 economic crisis, the country’s total debt surged from 150% of gross domestic product in 2008 to more than 250% of GDP today, according to The Economist. These problems are compounded by the fact that the economy seems less likely to be able to “grow out of the problem” these days.

Credit Suisse’s Andrew Garthwaite believes that these dynamics have led to a “triple bubble”, including the third-largest credit bubble of all time, the largest investment bubble, and the second largest real estate bubble. With near record producer price deflation, low growth in bank deposits, capital outflows, and falling housing prices, there is seemingly little hope for the economy to avoid the implosion of these three macro trends.

The solution to these problems is to restructure the damaged parts of its economy, including government-financed vehicles that have fueled the property boom. But, without a counterbalancing stock market that can absorb some of the pain from these restructuring methods, the government could see difficulty implementing these much-needed changes.

Investors looking to participate in the China story can do so in several ways.

The iShares China Large-Cap ETF (FXI A), iShares MSCI China Index (MCHI A), and SPDR S&P China ETF (GXC A+) are the three most popular U.S.-traded exchange-traded funds with exposure to the country’s equity markets (see Figure 3 below).

Investors looking to bet on a decline in China’s equity markets over time may want to consider purchasing put options or selling call options on these ETFs, although doing so is effectively betting on the government’s ability to control prices. For those uncomfortable with options, the ProShares UltraShort FTSE China 50 ETF (FXP B+) provides short exposure to the market by trading at two times the inverse of the daily performance of the FTSE China 50 Index.

Those looking to bet on a recovery – taking a contrarian point of view – may want to look at long-term equity anticipation securities (or LEAPS) as a potential leveraged play. With a multi-year time horizon, these option afford time for the market’s turbulence to sort itself out. Those seeking non-option exposure may also consider buying the ETFs outright, but it’s worth noting that the volatility associated with these securities is unlikely to abate anytime soon.

In the end, China remains at a key crossroads with regards to its economy and stock market. Painful reforms will be necessary to fix the problem long-term, but the government feels its necessary to protect the market in the near-term to enable those changes to occur.

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Disclosure: No positions at time of writing.