Key Points:

• Government interventions mask market realities
• Formidable challenges plague the economic landscape
• Keynesian expectations met with a Marxist response
• Short-term traders navigate volatility for gains
• Long-term investors await signals from the Third Plenary Session

Turbulence in the Chinese Equity Market

The CSI 300 Index managed a modest 0.7% gain on Monday, reaching 3,200 points, and a relatively moderate year-to-date loss of 6.7%. The apparent stability of the CSI 300 Index belies the heavy intervention from government funds of some of the leading stocks, including state-owned banks and energy companies. It has masked the brutal selloff of the vast majority of stocks in China’s equity market, which has not been actively supported by the so-called 'National Team'—a group of government-controlled investment funds tasked with stabilizing the market. Out of the 5,343 A-share stocks, a mere 8% (427 stocks) registered gains, while a staggering 91.7% (4,898 stocks) declined. A significant 3,206 stocks experienced drops exceeding 8%, painting a picture of widespread market turbulence on Monday.

Despite the efforts of the National Team, the Shanghai Composite Index fell by 1% to 2,702 on Monday, extending its year-to-date loss to 10.4%, while the Shenzhen Component Index dropped by 1.1%, pushing its year-to-date loss to a substantial 17.5%. The smaller cap indices fared even worse, with the CSI Small Cap 500 Index plummeting 2.3% on Monday, bringing the cumulative loss for the year to a staggering 19%. The distress is most evident in the CSI 1000 Index, composed of stocks with market capitalization below those in the CSI 300 and CSI 500. This index saw a sharp 6.2% decline on Monday and a staggering 27.1% year-to-date loss in 2024.

The overall market capitalization of A-shares has seen a daunting 14.6% plunge from RMB 77.6 trillion to RMB 66.3 trillion in just a little over one month in 2024. In Hong Kong, the Hang Seng Index and the Hang Seng China Enterprises Index have declined 9.2%, and 9.7% respectively while the Hang Seng Tech Index has plummeted 19.3% year-to-date. This cascade of losses indicates a troubling trend, underscoring the challenges and uncertainties plaguing the Chinese, including Hong Kong, equity market.

Stormy Economic Waters

The lacklustre performance of the Chinese equity markets is intricately interwoven with a tapestry of challenges confronting the nation's economy. The ailing property market, emblematic of broader economic struggles, requires an extended healing process. Anticipated defaults and bankruptcies of Chinese developers, both in their listed holding entities in Hong Kong and business and project entities on the mainland, loom large. The pervasive downward adjustments in home prices, essential for clearing a market burdened with excess inventories, suggest a prolonged period of correction and lingering negative wealth effects weighing on household consumption.

Moreover, the extensive overhangs in on-balance sheet and off-balance sheet debts, coupled with smaller land sale revenues constrain the fiscal flexibility of local governments and cast a shadow over infrastructural spending and the provision of local public services. Local government debts, coupled with shadow banking debt overhangs and wealth management product defaults, pose a potential threat to the stability of China's financial sector and its capacity to extend credits to finance the country’s economic activities.

As the economic recovery unfolds sluggishly and uncertainties persist, caution pervades entrepreneurs and private sector management, hindering new investments. Regulatory tightening, uncertainties, and apprehension exacerbate this cautious approach, perpetuating a self-reinforcing cycle of low confidence and an unfavourable investment environment. Large internet companies, in addition to facing highly competitive core markets and products, are weighing potential regulatory and crackdown risks cautiously and tend to refrain from expanding into new businesses, particularly high-risk or sensitive areas. Tencent, for instance, plans to voluntarily reduce its market share in the payment market to avoid becoming a rival to state-owned banks.

The Chinese equity market's predicament is further compounded by the projection by leading think tanks and street economists that the potential growth rate of the Chinese economy in the medium term is set to decline to 4% and further towards 3% in the longer term. Factors such as a diminishing working-age population, decreased fixed capital formation, and declining productivity contribute to this downward trajectory. The contribution of total factor productivity growth to real GDP growth in China has dwindled from over 4% in the mid-2000s to around 2.5% in recent estimates. Some economists anticipate this figure sliding further to an average of 1.3% over the next 10-15 years and constraining the Chinese economy’s potential growth rate (Peschel & Liu, 2022).

The external environment is also challenging, with the United States and its European and Asian allies adopting technology containment and supply-chain derisking away from China. In response to heightened geopolitical risks, multinational businesses have accelerated the diversification of supply chains and production capacities away from China to ASEAN countries, India, and Mexico, as well as reshoring back to the U.S. or Japan. This has a serious damaging effect on the Chinese economy. More recently, Trump has been threatening China with imposing tariffs over 60% if elected as the U.S. president in November. The introduction of a draft BIOSECURE Act to restrict federally funded medical providers from using the services of Chinese biotechnology firms and US Secretary of Commerce Gina Raimondo’s warnings about Chinese electric vehicles posing national security risks to the US and Europe are also recent examples of rising geopolitical tensions.

In this complex economic landscape, the Chinese equity market grapples not only with immediate challenges but also with the prospect of enduring and profound structural shifts. In this precarious economic climate, the downturn in the equity market transcends mere market dynamics; it becomes a symptomatic reflection of a larger, systemic issue.

Investors’ Keynesian Expectations Faltered by a Marxist Response

Equity investors, well aware of the persistence of economic changes illustrated in the previous section, have been anticipating and, for some, advocating for more forceful and larger-scale monetary and fiscal stimulus measures to boost the Chinese economy and loosen financial conditions. The Chinese authorities have been rolling out numerous stimuli that are relatively tepid and fall short of the 'bazooka' hoped for by investors. The timid policy response is unlikely to result from a lack of understanding by the leadership but rather a conscious policy choice.

President Xi initiated a nationwide deleveraging initiative in 2017, starting with crackdowns on the shadow banking sector, followed by the property sector and excessive local government debts over the years. There is no sign from the Chinese leadership of pivoting these strategic goals amid economic challenges. Also, in 2017, President Xi coined the concept of “high-quality development” at the 19th National Congress of the Communist Party of China (CPC), emphasizing the CPC’s priorities in technological self-reliance, a new development pattern, and food security through modernizing the agriculture sector. It signifies the transition of the Chinese leadership’s priority from pursuing high-speed economic growth to other considerations deemed more important. Previous development impetus that relies on massive inputs of labour, resources, and investments in capital assets is considered unsustainable, and the associated economic structure is deemed unbalanced. In our Q1 Outlook, we highlighted President Xi’s directives at the Central Financial Work Conference to adhere to Marxist political economy theories for reforming the financial system and his emphasis at the Central Economic Work Conference on high-quality development. We concluded that these remarks pointed to the sidelining of short-term growth stimulation.

Against this backdrop, the Keynesian stimulus measures in investors’ minds have found little empathy in the Chinese top authorities’ policy deliberation, and the stimulus bazooka has not arrived and is very unlikely to. The determination not to bail out failed property developers and shadow banking entities signifies that the deleveraging initiative from 2017 persists. Another example that illuminates the focus on high-quality development is the ban imposed on the 12 most heavily indebted provinces from making any new infrastructure investments, including projects under construction, without getting pre-approval from the central government.

The resistance to calls for Keynesian-style aggregate demand-boosting measures that can only lift short-term growth but not the long-term growth potentials of an economy has a sound foundation in neo-classical economic growth models. It is probably an appropriate policy choice under certain conditions, including a market economy, a vibrant private sector, a facilitating incentive system for both the private and public sectors, and a predictable, transparent, and stable regulatory environment. Should investors, entrepreneurs, and households see these contextual conditions improve, confidence may return to the economy and the equity market.

A less comforting development, however, is the absence of signs indicating that Chinese policies are moving towards increased marketization and energization of the private sector, as outlined in the 60-point decision of the Third Plenary Session of the 18th Central Committee of the Communist Party of China in 2013. The readout from the Politburo meeting of the CPC on January 31, 2024, remains silent about the timing of the Third Plenary Session of the 20th Central Committee that should have convened in October or November last year if the historical protocol is any guideline. The much-anticipated meeting would be an effective venue for the Chinese leadership to formulate and communicate its economic development strategies over the next five years, which have been the typical theme and agenda for a Third Plenary Session. The absence of the meeting and communication of such discussion arouses concerns and scepticism among market observers and investors.

According to the readout from the study session of the latest Politburo meeting, President Xi’s directives to the top brass of the CPC emphasize the pursuit of high-quality development through enhancing new quality productive force that comes from innovation in technology, innovation in the combination of factors of production, and transformation of industries. This is signified by enhancement in total factor productivity. The intertwining theme of the statement is the logic, concepts, and narrative of the Marxist political economy emphasizing productive forces and the relationship of production while the recognition of the decisive role of markets in allocating resources and the importance of the private sector found in the Third Plenary of the 18th Central Committee in 2013 was absent. Reading the communication tea leaves pare further the already timid probability of development strategies enhancing the role of the market and the private sector. Returning to the Marxist paradigm and an environment in which getting rich first is no longer glorious and government officials are incentivized to watch their steps carefully instead of pursuing growth with trials and errors, the economic challenge in the Chinese economy remains formidable.

Investment Implications

Navigating the tumultuous waters of the Chinese equity market poses challenges, akin to looking through the glass darkly. Government interventions, symbolized by the 'National Team,' offer only partial respite against the market downturn. This market turmoil intersects with broader economic struggles, encompassing a distressed property sector, impending defaults, and fiscal constraints of local governments. Entrepreneurs' caution, regulatory tightening, and external pressures compound the complexity. The interplay between Keynesian expectations and a Marxist response deepens the disappointment of investors, highlighting systemic issues beyond immediate market dynamics.

In this intricate scenario, it may be advantageous to remain nimble and flexible. Short-term traders can find opportunities amid volatility. The stocks of central state-owned enterprises and large-cap stocks of the CSI 300 Index and MSCI China A50 Connect will tend to benefit from the buying of the National Team. Meanwhile, longer-term investors may await clearer signals from the Third Plenary Session. Furthermore, research and accumulation of positions in industries benefiting from China's industrial tailwinds, such as technology and advanced manufacturing, remain strategic. Despite cyclical swings, themes like productivity enhancement and technology self-reliance persist. Additionally, sectors like energy and green metals, supported by enduring themes such as energy security and green transformation, present opportunities amid China's uncertain path to recovery.