China’s economy seems to be on the path of a modest recovery, as reflected in the improvement of many economic indicators. However, the stock market has continued to slide, declining by 11% so far this year. In fact, China’s domestic A-share market is one of the worst performing equity markets in the world. Moreover, the Shanghai composite also underperformed the Hong Kong traded H-share index (HSCEI) by about 13% this year.
Watching the relentless slide of the A-shares, many investors ask us what is wrong with the Chinese economy. The assumption is that the Shanghai composite is revealing some deep insights about the overall economy that we may have missed. But what are they? Here we try to look at the issue from a different angle: What is wrong with the A-share market? Why has the Chinese equity market performed so badly?
We would not dream to claim to know all the answers, but we think the following factors may at least partially explain the poor performance of the domestic equity market: the decline of company earnings; structural and governance issues; large supply of shares; and the draining of liquidity.
Earnings: Fundamentals do matter, of course. Corporate earnings have dropped sharply in light of the economic slowdown in the past few quarters. We estimate that earnings’ growth of listed companies (excluding financials) in the A-share market first dropped sharply and then turned negative this year. While listed banks continued to show good profits, the market is concerned about their future earning potentials and possible write-offs.
However, earnings cannot explain everything. Indeed, there seems to be a continued de-rating in the A-share market in the past three years, with the current price-to-earnings ratio lower than during the global financial crisis.
Structural and governance issues: Despite progress in stock market reforms in recent years, structural and governance issues remain and continue to plague China’s equity market. They include problems in the initial public offering (IPO) process, insufficient transparency in company disclosures, inadequate investor protection, insider trading and other market order issues.
These issues may in part stem from the fact that the government often sees the stock market more as a source of financing for the economy than as a way to improve capital allocation. The China Securities Regulation Commission (CSRC) has launched new reform initiatives since 2011 to tackle some of these issues, which has been welcomed by the market but it will take time to see major progress.
Supply: Despite the poor performance of the A-shares, there has been large amount of IPOs and share issuance in the market. In fact, Chinese companies raised more capital from the equity market in 2010 than in 2007, when the market boomed. While 2012 has proven a particularly challenging year for capital-raising, the long pipeline of IPOs has nevertheless affected market sentiment.
In addition, according to estimates from data provider Wind, a total of RMB8.5 trillion worth of shares have been unlocked (from previous IPOs, new share issuance, selling by original majority shareholders, and non-tradable share reforms) since the beginning of 2010, though the amount has tapered off in 2012. The large potential selling pressure may have placed a heavy weight on the market.
Liquidity: Perhaps reflecting the erosion of investor confidence, partly due to the above factors, the A-share market has suffered net fund outflows. According to estimates made by WIND, the A-share market has suffered net fund withdrawal in every quarter since Q1 2010.
Although the government expanded the quota for and accelerated the approval of qualified foreign institutional investors (QFII) since late 2011, that has proven too little and perhaps too late to change market sentiment. While the new approvals of QFII in 2012 reached US$12 billion at the end of October, compared to US$1.9 billion in 2011, total accumulated QFII approvals only amounted to US$33.6 billion, which is tiny compared to the total tradable market cap of the A-share market (RMB15.5 trillion).
Where does this leave us? Our A-share strategist Chen Li is positive about 2013, after being bearish for an extended period of time. In the coming quarters, we do expect corporate earnings to recover, along with the economy, as destocking ends and output prices recover.
We also expect the authorities to continue to push for IPO reforms and improvement of disclosure and supervision, which should eventually help improve market confidence. The participation of institutional investors, both domestic and international, should also grow over the medium term. Just know this – the performance of the domestic equity market is not so tightly correlated with the overall economy.
Wang Tao is the head of China economic research at UBS investment