Abstract: Since the outbreak of the Russia-Ukraine conflict, China’s capital markets have experienced a sharp correction, with Chinese stocks listed overseas and in Hong Kong plunging the most, making them the hardest-hit asset classes globally except for those of Russia. This round of correction was caused by both international and domestic factors, but the root cause is the weakened confidence of long-term investors at home and abroad in China’s growth prospect.
I. SHARP CORRECTION OF CHINA’S CAPITAL MARKETS AFTER THE OUTBREAK OF THE RUSSIA-UKRAINE CONFLICT
After the outbreak of the Russia-Ukraine conflict, China’s capital markets experienced a volatile correction, with Chinese stocks listed overseas and in Hong Kong plunging the most, making them the hardest-hit asset classes globally except for those of Russia. Overall, from US-listed Chinese shares to Hong Kong shares to A-shares, the farther the market from Chinese mainland, the greater the magnitude of the correction. Between February 24, 2022 and March 15, 2022, US-listed Chinese stocks declined by 32%, Hang Seng Index by 20%, CSI 300 Index by 12%, and the Shanghai Composite Index by 11%.
As for US-listed Chinese stocks, multiple risks have caused the sharp fall. Since the beginning of 2021, US-listed Chinese stocks began to see a downward correction, mainly driven by the market’s concerns over the outlook of the Chinese and US financial markets, the risk of Chinese companies being delisted from the US, and some of China’s industrial policies. The recent dive of US-listed Chinese stocks is directly triggered by the Russia-Ukraine conflict, coupled with the shock of potential delisting of the stocks by the US Securities and Exchange Commission (SEC), which fueled market anxiety over the prospect of Chinese companies listed overseas. As for Hong Kong stocks, given that the market is characterized by its cyclical fluctuations and the dominance of institutional investors, the plunge mostly reflects pricing of China’s economic fundamentals and the geopolitical risks. The risk premium of the Hang Seng Index surged to a historic high level, much higher than that in 1998, 2008, and 2012. As for A-shares, experience shows that they are largely influenced by domestic liquidity condition. However, this round of correction occurred without signs of significant tightening of monetary and credit conditions, indicating that there are deeper causes.
II. CAUSE OF THE CAPITAL MARKET VOLATILITY
This round of drastic correction of China’s capital markets is caused by both international and domestic factors. Internationally, geopolitical conflict is the main factor. The reason why the impact of the Russia-Ukraine conflict has surpassed that of ordinary regional wars and led to great turbulence in the global financial market is that it will have far-reaching impacts on the global economic order and political landscape which are being reshaped along multiple dimensions, such as trade, finance, supply chains, and arms race.
Some foreign investors thought that China’s market is becoming “uninvestable”, fearing that amid the geopolitical conflict, the impacts of the US financial sanctions would spill over into China. Capital outflow has confirmed this concern. It not only occurred in the stock market, but also in the bond market in February which saw a large net capital inflow.
Domestically, the main factor is the downward pressure on China’s economy. Last year, the Central Economic Work Conference pointed out that the Chinese economy is facing triple pressures of demand contraction, supply shocks, and weakening expectations. Demand contraction is manifested in the decline of external demand and real estate investment, and weak recovery of consumption. It is also related to last year’s fiscal tightening, monetary tightening, and regulatory tightening in the real estate sector. Supply shocks are reflected in constraints on the industrial and service sectors, mainly including the recurrent outbreaks of the pandemic, worsened trade conditions, and the “dual control” policy. Weakening expectations are caused by increasing downward pressure on economic growth.
This year, the policy response to the triple pressures is targeted and clear. Based on economic conditions, the policy mix has been adjusted, featuring loose fiscal policy, prudent monetary policy, and policy aimed at stabilizing the real estate sector. But the effect of the policy is yet to be seen. Further weakening market expectations might be related to the fact that the policies introduced thus far are falling short of market expectations. For example, after bottoming out in January, China’s total social financing in February was far lower than expected. Against this backdrop, the market had expected that the central bank would lower policy rates. Yet in March, the medium-term lending facility (MLF) and the loan prime rate (LPR) remained unchanged, dashing market expectations.
The root cause of the sharp market correction lies in the weakened confidence of long-term investors at home and abroad in China’s economic growth in the long run. Although the Russia-Ukraine conflict has acted as the catalyst, it is not adequate to explain why China’s capital markets experienced such a volatile correction. For the A-share market, in the absence of significant tightening of monetary and credit conditions, rate hikes in the credit market, and deceleration in total social financing, short-term factors like resurgence of the pandemic and poor economic data would not lead to a double-digit decline in the stock market. Therefore, the correction of the A-share market has deeper causes, which are weakened market expectations and confidence that have affected the long-term valuation of the capital markets.
On March 16, the Financial Stability Development Committee under the State Council held a special meeting to study the economic situation and capital market issues. After that, the People’s Bank of China, China Banking and Insurance Regulatory Commission, China Securities Regulatory Commission, the Ministry of Finance, and the State Administration of Foreign Exchange stated that they would implement the spirit of the special meeting, stabilize market expectations, conduct research and put forward effective solutions to prevent and defuse risks in the real estate sector. The statements immediately shored up market confidence and relevant policies have received positive response from the market. But the response is more the result of short coverings. So far the market is still short of long-term investors. Rather than what the authorities say, the market is expecting to see how the policies will be implemented.
III. LOWER BENCHMARK INTEREST RATES ASAP AND INCREASE FISCAL SUPPORT TO STABILIZE INVESTMENT
Facing the changing conditions domestically and internationally, China should focus on its own tasks and take development as the top priority. It needs to step up efforts to keep economic operation within a reasonable range, so as to rebuild the market confidence in China’s long-term economic growth. This is the only right way that is conducive to China’s sustainable development and can help China cope with the evolving international landscape. Specifically, there are three policy suggestions:
First, it is essential to roll out and implement stabilization policy in time to maintain the stability and consistency of policy expectations. At present, the government has put forward a series of policies to stabilize growth, which has shored up market confidence for the moment. However, to transform the rebound of the capital markets into a robust cycle that can enable a positive feedback loop between the capital markets and real economy, the key is to put into effect stabilization policy so as to anchor or even reverse market expectations.
Second, prudent monetary policy should play an active role to reverse the credit cycle. Under the triple pressures, monetary policy should step up its support for the real economy. Benchmark interest rates should be lowered as soon as possible to reduce the overall market interest rates and the operating costs of companies in the real economy, sending the market a signal about the country’s determination to stabilize economic growth. Credit expansion should be increased to stimulate the financing demand in the private sector and stabilize business and market confidence.
Third, fiscal policy should accelerate the spending progress, improve the efficiency of special bond utilization, and enhance efforts to stabilize investment. Some research estimated that to achieve a GDP growth of 5.5% this year, the growth rate of infrastructure investment in China should reach 6%. To that end, adjustments should be made to the budget structure to increase the support to infrastructure investment, make more transfer payments to local governments, provide subsidized loans for infrastructure investment, and so on.
This article is part of the CF40 Briefing Series.
