The mainland stockmarket plunged nearly 4 per cent on Wednesday after hitting a fresh record earlier in the day, as heavy profit-taking by mutual funds was triggered by sharp falls in Hong Kong’s market, traders said.
The Shanghai Composite Index closed 3.81 per cent lower at 4,300.563 points, after rising as much as 0.7 per cent to a record intra-day high of 4,502.296 in the morning. It tumbled as much as 4.16 per cent at one stage.
Stocks fell across the board, with losing Shanghai shares overwhelming gainers by 790 to 89. Turnover in Shanghai A shares expanded to 168.1 billion yuan from Tuesday’s 148.3 billion. Half a dozen traders and analysts said the market’s tumble, the biggest fall for a month, was not caused by negative news or policy rumours, but occurred because stocks were vulnerable to profit-taking after surging 15 per cent since July 19.
Many traders had seen 4,500 points as a target for the index, and began selling near that level as Hong Kong stocks slid in response to weakness on Wall Street. Selling snowballed as mutual funds rushed to cash in gains. “Funds seem to have decided to take some of their money off the table because the market rose so fast recently,” said Tang Zhenbin, analyst at Hongyuan Securities.
Technically, the index showed classic signs that its uptrend had ended for the short term, forming a bearish engulfing pattern at its high as 14-day momentum showed a negative divergence. Some analysts said investors were concerned that authorities might take further action to cool the market if it climbed too fast. The index plunged as much as 21 per cent after it hit its May peak as the government hiked the stock trading tax.
Investors were worrying about further policies by the authorities after Friday’s sudden hike of bank reserve ratios, and they remember the pull-back in May,” said Zhang Yanbing at Kinghing Securities. But the index held initial technical support near 4,300 points, close to where it peaked in May and June, and many analysts said they did not think a long-term decline was starting.
First-half corporate profits are proving strong while stock turnover remains much lower than it was in May, suggesting trade has not become wildly speculative and authorities may not feel compelled to intervene in the market. Bank of Communications Schroders Fund Management said it had raised the targeted 12 billion yuan for a stock fund it launched on Wednesday within half a day. Earlier, ABN Amro’s fund arm in China and Great Wall Fund Management said they had each raised 12 billion yuan for their new stock funds. The fund news suggested there would be plenty of new money to buy into any market weakness.
In recent weeks authorities have quickened their approvals of new funds, apparently to ease concern among investors about the market’s ability to absorb a series of initial public offers expected later this year. Coal, steel and metal shares led the market down on Wednesday after their strong performance in the past several days, as some investors became cautious about valuations of those stocks. Datang Coal dropped 4.32 per cent to 34.31 yuan, after soaring 34 per cent over the previous seven trading days.
Among banks, industry leader Industrial & Commercial Bank of China slipped 3.66 per cent to 5.53 yuan. But Jiangxi Wannianqing Cement jumped its 10 per cent daily limit to 10.15 yuan after saying it would form a 1 billion yuan joint venture with China National Building Material. Jiangxi Wannianqing had been suspended since July 16 pending an announcement.
Loose credit policies are threatening a fresh spate of bad loans, the mainland central bank warned in a report aimed at regional governments and local lenders.
Excessive leveraged investment in fixed assets and a high concentration of long-term loans have increased the chances of loans turning sour, according to the China Regional Financial Stability Report, released by the Shanghai office of the People's Bank of China.
"Banks' credit concentration is quite high, the structural problem of a high proportion of medium- and long-term loans shows no sign of abating and there is growing pressure of a rebound in non-performing loans," the China Business News quoted the report as saying.
The renewed warning on bad loans chimes in with recent government calls to cool over-investment and tighten credit policy amid fears that excessive liquidity is leading to overheating.
From today's South China Morning Post, "Stock market returns have generated more than 20 per cent of the first-half profits for mainland-listed companies that have reported interim results so far, according to a report, underscoring concern that the recent earnings-driven domestic market rebound is ungrounded."
I had been hearing rumors all year that a significant source of corporate profits had been from speculating on the stock market but I hadn't yet seen any numbers. For many the logic for continued speculation seems pretty strong -- insider activity is extremely profitable and there are few real restrictions on the ability of corporate treasurers to trade on their own and shared insider information. This makes it seem like a money machine.
My guess is that unless the financial authorities take strong countermeasures (unlikely), for the rest of the year we are going to see the market caught in a virtuous circle of stocks rising on stronger earnings, and rising markets leading to greater speculative profits and so stronger earnings.
According to today's New York times, China has already taken more than $600 million in paper losses on its $3 billion purchase of Blackstone shares. Just earlier today one of my students had sent me a copy of a piece by Larry Summers that appeared in the Financial Times warning about the political implications of sovereign wealth funds and suggesting that they needed to be monitored and regulated diffeently than other funds.
My response to him was that we were all getting a little overexcited about the political implications of these funds. It is not at all clear to me that funds whose investment strategies are so likely to be subordinated to political considerations (and political leaders) are going to be highly successful as investors, and I suspect that the losses on Blackstone, like the copper trading losses last year, will be part of a long series of trading disasters that will occur as China -- tremendously inexperienced in money management and risk management -- deploys its out-of-control accumulation of international reserves.
As for whether or not there are likely to be dire political consequences of sovereign wealth funds, I am also skeptical. It's great for the scare-mongering press but neither OPEC, the Chinese nor other Asian central banks have enough to invest to make a serious difference to the political needs of Europe or the US, and anyway when a foreigner owns substantial amounts of assets in your country, you have far more leverage on him than he has on you. I think the only real effect is that until they learn how to do it well and efficiently the result will be a net transfer of wealth from the sovereign wealth funds to the rest of the world.
Today's WSJ says "China may show a slowdown in export growth starting with July's trade data, but the shift -- from a tax-policy change rather than concerns over recalls -- is expected to be limited."
I think the WSJ is right not to be overly impressed about the size of a possible shift. We've been told since at least 2003 that the latest round of recording-breaking monthly surpluses are likely to be the last, but that has never turned out to be the case, and I think it is unlikely that we will see a sharp drop until there is a change in monetary policy.
China's trade surplus is part of the monetary trap in which it finds itself. Capital inflows, caused in large part by the trade surplus, but beefed up by FDI and portfolio inflows, lead directly to monetary expnasion since, under China's currency regime, the role of the PBoC is largely limited to funding the purchase of the hundreds of billions of dollars that pour into the country. A consequence of this monetary policy is, of course, loan and investment expansion, which itself results in greater industrial production.
Since a country's trade surplus is simply the excess of its production over its consumption, China's monetary expansion condemns it to rising trade surpluses, which themselves cause further monetary expansion. We will need something a little more dramatic than a reduction of export tax subsidies to end this game.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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Regional 
October, 2007