China A-shares upheaval brings openings, headaches

The patchwork quilt of measures China's government has taken since late June to prop up the country's plunging A-shares market is presenting overseas investors with opportunities as well as reasons to lose sleep.

Among the opportunities: The 33% plunge by Shanghai's composite index from the market's June 12 high through its recent low on July 8 — following an explosive, retail investor-led surge of 150% over the prior eight months — has raised the prospect of a return to more attractive valuations.

The market's “short-term correction” could be “a good opportunity for us to invest,” said Wu Yibing, head, China, with Temasek Holdings Pte. Ltd., at a July 7 news conference on the S$266 billion ($197 billion) Singapore-based sovereign wealth fund's latest fiscal year results. As of March 31, Temasek's investments in China came to roughly S$72 billion.

For now, the tug of war between a government looking to buoy the market and hordes of Chinese retail investors newly aware of the risks posed by the trillions of yuan of margin debt they took on in the market's runup will determine how big that window of opportunity could become.

The window closed a bit toward the end the week ending July 10, as the government tightened its grip on the market, effectively engineering a two-session, 11% bounce that saw the Shanghai index close at 3,877.80 on July 10 — but still down 25% from its mid-June high.

Meanwhile, the government's ever-expanding litany of steps aimed at boosting stock purchases and discouraging selling are presenting tactical openings for investors as well. (The latest additions include a six-month ban on sales by “insiders” holding more than 5% of a company's stock and an increase in the ceiling for insurance company equity allocations to 40% from 30% of their general accounts.)

For example, with hundreds of smaller-cap companies listed in Shenzhen and Shanghai having suspended trading in their shares as the market plunged, retail investors facing margin calls have been selling their holdings of H-shares — listings by mainland companies on the Hong Kong stock exchange — even though valuations there already are attractive, said William Fong, a Hong Kong-based portfolio manager with Baring Asset Management (Asia) Ltd. in a July 8 telephone interview. “We are quite excited to bottom fish there,” Mr. Fong said.

The Hong Kong-based head of China equity for one global money management firm, who declined to be named, said his firm is seeing a growing number of overseas investors with H-share exposure looking to add A-shares as well, but leaving it to the manager to decide which market to favor at any given time.

Gary Greenberg, the London-based head of emerging markets with Hermes Investment Management, said his team has compared the two and found companies listed in Shanghai and Shenzhen — such as Guangdong-based Gree Electric Appliances Inc. — far more entrepreneurial than the mature blue chips listed in Hong Kong.

With the market's retreat, Gree, with a return on equity north of 20%, has seen its price-earnings ratio drop to less than 7 from an already reasonable 10 — the kind of gem to be found in the A-shares market even as observers had warned that valuations there were getting frothy, Mr. Greenberg said.

Those losing sleep, meanwhile, are concerned that a clumsy policy response to the market downturn could exacerbate the ongoing slowdown of a Chinese economy that's been the main engine of global growth since the 2008 financial crisis.

“What's happening in China is quite scary,” said Martin Todd, portfolio manager on the European equities team at Hermes Sourcecap. To the extent the market's retreat undermines consumer spending in China, that could further slow already weak demand for European companies with big exposure to emerging markets, Mr. Todd said.

To many observers, the seemingly frantic succession of market-support measures announced by the government, regulatory agencies and financial industry groups has been exceedingly clumsy.

Such direct equity market intervention makes price discovery “almost impossible,” a development that will likely shift the focus of foreign investor concerns from access to transparency, said Manishi Raychaudhuri, Hong Kong-based Asia regional equity strategist with BNP Paribas Securities.

Even if the market's fall has been sizable and leverage is a concern, it's still not obvious why the government appears so nervous, said Nicholas Yeo, the Hong Kong-based director and head of equities (China/Hong Kong) with Aberdeen International Fund Managers Ltd. Mr. Yeo speculated that perhaps the powers that be have information showing more leverage in the market now than official margin financing totals suggest.

Some of the government's recent moves — including cuts in interest rates and reserve requirements — come straight out of the traditional policy playbook.

Others, however, have left some observers scratching their heads, including:

nquadrupling the capital of China's official margin lender to brokers, the China Securities Finance Corp., to 100 billion yuan ($16 billion);

nallowing retail investors for the first time to pledge their homes as collateral for margin loans;

neffectively suspending margin calls for outstanding financing;

ngetting 21 leading brokers to funnel up to 15% of their own capital, for a combined 120 billion yuan, to buy stocks, and committing not to sell until the Shanghai composite regains the 4,500 level; and

nprompting the domestic investment arm of the $653 billion sovereign wealth fund China Investment Corp., Beijing, and leading insurers to buy A-shares-focused exchange-traded funds.

The full-court press to keep domestic investors in the market has followed what was supposed to be the A-shares market's coming-out party for overseas investors — MSCI Inc.'s June 9 decision on whether to add an initial sliver of China's domestic equity market to its global emerging markets benchmark indexes.

While ultimately deciding, for a second year in a row, not to do so just yet, MSCI praised China's government for making considerable progress in opening the country's capital markets and said the two would work closely to address remaining concerns.

As of June, China had awarded foreign investors a combined $139 billion in quotas to invest in the country's domestic capital markets, while two new programs were launched over the past nine months to open up investment flows between Hong Kong and the mainland.

Asked about the recent spate of interventions by Chinese regulators, Chia Chin Ping, MSCI's Hong Kong-based head of research, Asia Pacific, said MSCI remains focused primarily on whether overseas investors can freely access and exit a market.

Market veterans described the government's interventionist turn as a setback on the road to reform, and one that could push back the day when institutional investors from developed markets move to add A-shares as a strategic allocation in their portfolios.

At a time when foreign investors should be thinking about getting exposure to “the most vibrant stock market in the world,” heavy-handed intervention by China's regulators will serve as a “reality check,” predicted Wang Qi, a founder of China Forward Capital Group Ltd., the Hong Kong-based marketing arm of alternatives firm Shanghai MegaTrust Investment, where he is a partner and advisory director.

The seeming urgency of the government's response will only bolster those investors' sense that China remains a “command-and-control” economy, with an “opaque” market, Mr. Wang said. Longer term, overseas investors will come to the market, but this episode could leave more of them favoring tactical approaches as opposed to making strategic allocations, he said.

A number of market players in the region, while conceding the government's intervention is a setback, said such episodes are to be expected in a country with such a brief history of financial markets.

China's leadership remains very keen to bring more foreign participation to the A-shares market to make it more institutional, but in its “own way, and its own time,” said Stewart Aldcroft, Hong Kong-based CEO of CitiTrust Ltd. With less than 20 years of market experience, China “still has a lot to learn,” and the current moment will be a learning experience, Mr. Aldcroft said.

Market players say the sooner China's leadership returns its focus to the real economic reforms needed to shift the country's growth engine toward domestic consumption and away from exports, the better it will be for domestic markets.

The past month “is a short-term setback,” but longer term, the commitment to reform is still there, Aberdeen's Mr. Yeo said. “I'm still a believer,” that China's government is aware of the paramount importance of pushing through those needed reforms, because without them, there “is no more China story,” he said. n