Executive Summary

  • China’s onshore markets experienced a pullback in June
  • The underlying factors that caused the onshore markets to rise are still intact.
  • The government has met the pullback with a powerful intervention

July 16, 2015 – A strong stock market benefits China’s key policy goals: Renminbi (RMB) internationalization, increased domestic consumption, and unlocking shareholder value in state owned enterprises. The markets’ more prominent role in helping China achieve these goals is one explanation for the rise in the onshore markets, which are up 110% over the past year1. Due to this increased emphasis, China met the recent pullback with a powerful intervention. The cause of the pullback and the Chinese government’s actions to contain it can be confusing to investors outside of China. In this piece we provide an up to date overview of the onshore markets and outline why we believe China is still an attractive investment opportunity.

Recent Events

Stock investing in China is still a new concept and the majority of Chinese households have less money in the markets than those in the United States. Market exposure on a household basis has yet to be institutionalized in China like it is in the U.S., for instance there are no 401k plans in onshore China, thus the market’s drop adversely effects a smaller subset of the population in China than it would in the United States.

In the U.S. the savings rate is 5.1%2 with 25% of net worth going into the markets3. In China the savings rate is an impressive 50%4, however, according to China economic research firm PRC Macro, the average household only has 4.4% of their net worth5 invested in the stock market. Based on this comparison, China’s household participation in the stock market compared to its savings rate is relatively low. China’s leadership understands this disparity and has encouraged its people to invest in the capital markets to bring their participation rates up to par with developed nations and to institutionalize the market. This trend is apt to continue in the years to come, which could act as tailwind for investors.

Reasons for the June pullback

With such a massive influx of investors into the markets as China is currently experiencing, there is bound to be some measure of volatility. The adoption of margin6 by investors with little stock market experience struck us as imprudent. We believe overextension of margin was the primary cause of the June pullback.

Individual retail investors, who represent 85%7 of the market in onshore China, invested heavily in small cap stocks. These individuals bought on margin, leveraging their capital to cover the costs. Before the decrease in Chinese stock prices in June, brokerage margin increased as the onshore market performed well over the last year. In addition, as the markets continued to grow, the use of over the counter (OTC) margin increased. OTC margin is money leant by non-brokerage firms outside of the regulated markets and, in the case of China, allowed leverage upwards of three to five times the money deposited. While it is difficult to gauge exactly how much OTC margin was in the markets at their peak, between the months of March and May of 2015, it is estimated to have been between 1.5 and 2 trillion RMB8.

When a large number of Initial Public Offerings (IPOs) and secondary offerings took place in June, Chinese investors started selling their small cap shares in order to invest in the IPOs. As a result, supply overwhelmed demand and triggered a cascade of selling that led to a significant amount of margin calls. A margin call occurs when a broker asks for more capital from an investor to cover a decrease in value of a stock.

Halted and Suspended Securities

In order to prevent large numbers of investors from being forced to sell due to compounding margin calls, regulators took the unprecedented measure of allowing companies, particularly small cap companies, to voluntarily halt trading in their stocks. The regulators realized that OTC margin, which is outside the scope of their regulatory purview, had the potential to be a systematic threat to the stock market. While stocks halted, regulators could deleverage both brokerage and OTC margin accounts. OTC margin has fallen 66% in the last several weeks alone due to this effort.9 Our partners in onshore China have reported that the OTC margin business has been largely shut down.