Will the Party 'Save' China's Imploding Stock Markets?

Fried chicken...or fried rat? That's the real question about what's in Chinese stocks.

There's been a silly controversy about a customer who found a rat-shaped piece in a KFC order. As it turned out, the piece was only rat-shaped but was wholly chicken meat. For some reason, this episode reminded me about the debate about corporate governance issues among PRC-listed firms: How much disclosure is being provided by these firms? Moreover, is Chinese-style accounting to be trusted? Explaining why he didn't invest in PRC-listed assets, famed investor Bill Gross called them the "mystery meat" of the financial world for this very reason. Are the Chinese serving up fried chicken...or fried rat? Unfortunately, it remains hard to tell.

If you enjoy financial adventure, then there is no finer place to invest than in China. In 2015, its stock markets have been both the best-performing and worst-performing in the world due to wild gyrations. Daily moves of ±5% are the norm and not the exception. During the last few sessions, for instance, the Shanghai Composite Index has fallen an astounding 19% in 9 trading days:

Friday was another black day in recent times for Chinese stock markets. The stocks, as suggested by Shanghai Composite index, nosedived 7.40 per cent for the day to mark their biggest daily point-wise fall in more than seven years. Regional indices too were hit badly, with Shenzhen Composite ending 7.9 per cent lower. Selling was seen across the board, with nearly 2,000 of 2,800 listed companies on Shanghai and Shenzhen exchanges hitting their 10 per cent-daily limits. limits.

That was harsh, but nothing new for Chinese stocks given the recent trend. The stocks have been bleeding over the last 9 trading sessions. In fact, the Shanghai market — which is nearly three times bigger than India's stock market in terms of market capitalisation — has lost a fifth its weight during the period. 

Also:

China’s $8.8 trillion stock market has plunged from first to worst on global performance rankings, threatening to bring an end to the longest bull market since the ruling Communist Party introduced equity trading to the world’s largest population in 1990. Morgan Stanley advised clients to refrain from purchasing mainland shares in a report on Friday, saying the Shanghai Composite’s June 12 high likely marked the top of the rally.

Market observers generally agree that the Chinese Communist Party has goaded retail investors through a relentless state media blitz about the benefits of investing in equities. To sweeten the pot, it has enabled these neophyte mom-and-pop investors to borrow considerable amounts to buy stocks. The end result has been fascinating to watch: Amidst a visibly slowing Chinese economy, stock markets kept rising as debt-fueled retail investors tried to cash in on a supposedly "government guaranteed" bull run. Once in a while, though, the reality becomes evident that (a) the Chinese economy is slowing, (b) unsophisticated mom-and-pop investors gorged on debt are driving this run, and (c) everyone expects the government to goose the market when it slows.
 
But here's the thing: what if the PRC cheerleaders shut the hell up and the government simply says "Well, that's just the way it is with stocks?" Recent movements have left the propagandists speechless:

Only months ago, encouraging words from Xinhua sent stocks soaring. Now, with markets sinking, that official line has gone quiet, leaving many wondering how -- or whether -- Beijing might respond. Just how much China’s state media are used to telegraph government views on the markets is the subject of debate. Xinhua, founded in 1931 as the Red China News Agency, didn’t answer calls to its news hotline seeking comment.

But analysts agree that Xinhua, a ministry-level government department, is too powerful to ignore. If nothing else, reports and commentary by state media sway investor psychology and can turn a rout into a rally -- or vice versa. “Investing in China stocks means you have to follow state media,” said Nelson Yan, the chief investment officer at the Hong Kong unit of Changjiang Securities Co. Government policy, after all, has been largely behind the world-beating 124 percent market gain of the past 12 months.

What to do? Call me crazy, but I prefer to invest in companies that observe good corporate governance: they have real and verifiable earnings, real and verifiable assets, and some semblance of an intelligible business model. Hoping that the Chinese government will keep talking up the market does not sound like a wise investment strategy to me. More often that not, Chinese listed companies have none of these things, leaving us to guess what Chinese apparatchiks are serving up: fried chicken...or fried rat?

Given recent headlines, it seems even gullible mom-and-pop investors in China believe the latter.

Caveat emptor!

UPDATE: Bang on schedule--call it the PBoC put--the People's Bank of China has reduced the benchmark lending rate for the fourth time since November 2014, while reducing reserve requirements as well. The timing suggests that the tanking stock market again drove monetary policy-making. Can the Party keep the stock market party going? I didn't even bet on it either way.