China worried that coronavirus would cause a market meltdown. Its reaction risks stoking a bubble instead

March 6, 2020, 10:06 AM UTC

China’s desire to support its financial markets in the wake of the virus outbreak may have moved the needle too far the other way.

It’s taken a sweeping and coordinated effort from top officials to prevent a downward spiral in Chinese stocks. From early February, the central bank and regulators across the foreign exchange, securities, banking and insurance sectors have deployed a number of measures to ensure sufficient liquidity and reduce borrowing costs for companies. Hints of more to come on the monetary and fiscal side have been equally effective.

While a stable equity market and the lowest sovereign bond yields since 2002 are good news for companies trying to raise money, critics caution that the exuberance triggered by such measures could be dangerous. Taking market-support policies too far may encourage the whirlwind trading that fueled massive bubbles in 2015 and 2007.

High leverage in the stock market is one notable sign, as well as surging daily turnover. There’s also been a rush to buy mutual funds, pour money into shiny new ETFs or buy higher-yielding convertible bonds. Perhaps most telling: a gauge of small cap stocks, where speculative trading is rife, has surged more than 20% since its low last month.

“Authorities want a strong market,” said Zhang Yankun, a fund manager with Beijing Hone Investment Management Co. “While we seem to have achieved that for now, there’s the risk of overshooting if gains extend further. There’s still great uncertainty over the pace of an economic recovery.”

The intensifying appetite to buy just about everything in China makes it a prominent outlier against a global backdrop of panic. While mainland shares buckled Friday as a global sell-off accelerated ahead of the weekend, the Shanghai Composite Index held up better than other benchmarks in the region. It still posted its best week in a year.

Attempts from officials in countries like the U.S. and Japan to instil confidence have either not lasted or have fallen flat, leaving investors there with the steepest losses and wildest swings since the global financial crisis.

Policymakers in China have long faced a tricky balance when it comes to supporting growth without fueling bubbles. Capital controls limit investment options for its citizens, which means excess liquidity typically flows in domestic assets such as housing, equities as well as more esoteric choices including garlic, cotton and certain teas.

Back in 2007 the Shanghai equity benchmark quadrupled in a year as the economy boomed and investors sought returns that would beat rampant inflation. The frenzied speculation briefly created the world’s first trillion dollar company after PetroChina Co.’s IPO, before higher taxes on trading shares and a series of interest hikes popped the bubble, with later declines greased by the global meltdown that ensued.

In 2015, officials faced a similar dilemma — and result — when the stock market doubled in value to $10 trillion in about 120 days. Attempts to curb margin trading, including tightening lending and draining cash from the financial system spooked investors, and the Shanghai measure collapsed more than 40% in a matter of months.

It is notable that this time round, the central bank has been cautious about injecting too much liquidity. It’s refrained from adding cash through daily money market operations for 14 days and didn’t follow the Federal Reserve in cutting interest rates this week.

Valuations are also nowhere near 2015 levels — the Shanghai Composite trades at 11 times its members’ projected earnings, versus a peak of 19 times in 2015. In the U.S., the S&P 500 Index currently trades at 17 times profit.

Ensuring stock prices can keep rising at a steady pace has been an effective way to shore up confidence among China’s mom-and-pop investors, who still drive the majority of trading.

“The virtual prosperity we’ve seen in capital markets is much needed at a time when the real economy is suffering,” said He Qi, a fund manager with Huatai-PineBridge Fund Management Co. “You need at least one venue to keep people’s spirits up.”

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