CHINA BUBBLE

China’s stock market boom has reached outright mania, with equities galloping higher at a parabolic rate, despite threats of a crackdown by regulators and the continued slowdown of the national economy.

The Shanghai Composite Index has risen 32% in the past six weeks, blowing through 3,000 to a three-and-a-half-year high even though corporate earnings are declining steeply.

The China Securities Regulatory Commission said late last week that it would "increase market supervision, resolutely crack down and earnestly safeguard normal market order." It warned that stock manipulators had been "raising their head" and would be dealt with.

The cautionary words have been ignored by retail investors as they throng brokerage offices, lured by momentum trades. The government itself is partly responsible for letting the genie out by talking up "cheap stocks" in the official media two months ago, but now appears alarmed by what it has done.

Many families are taking out brokerage loans to buy stocks, increasing leverage and risk. Margin debt has risen to more than $130bn from nothing three years ago. This is now 1.2% of GDP. "Turnover, leverage and account openings have all soared and there is a sense of mania taking hold," said Mark Williams, from Capital Economics.

The latest surge follows a shift by the Chinese authorities towards "targeted easing" in October, intended to stop the housing market crumbling after five months of falling prices. This was followed by a surprise cut in interest rates last month.

But aspects of the equity surge are bizarre. Financial stocks have jumped most, yet the rate cut was negative for banks since it reduced their margins. Deflationary pressures are eroding wafer-thin profit margins.

Chen Long, from Gavekal in Hong Kong, said the momentum on the Shanghai bourse has become unstoppable but is losing touch with economic fundamentals. "When the tide recedes, the backwash is likely to be vicious," he said.

In one sense Chinese stocks are cheap after the battering they have taken since the Shanghai index topped 6,000 on the glory days of the pre-Lehman boom. It has lost two-thirds of its value from the peak, one of the worst bear markets in any major country in the past century.

"The equity market has been trading at distressed levels," said Kenneth Chan, from Jefferies. China’s excess level of savings "needs to find a home" and there is nowhere else to put it, he said. Less understood is that excess liquidity generated by China’s growing trade surplus is also leaking into equities.

Even so, the stock boom comes as Chinese industry battles with massive overcapacity in everything from steel to shipbuilding, coal output, cement and solar panels.

The latest trade data show that export growth fizzled to 4.7% in November. The details are revealing. They showed that China’s steel industry is flooding the world with excess output after a 45% collapse in prices at home. Steel exports were up 55% to 9.72m tons from a year earlier, more than the entire production of the US.

Investors are effectively betting that President Xi Jinping will revert to China’s bad old ways of reflexive stimulus rather than sticking to his "tough love" plans to wean the economy off excess credit – now dangerously high for an emerging markets economy at 250% of GDP.

"People think there are rays of hope and that maybe stimulus is on the way, but we don’t think monetary policy is really changing. There still hasn’t been a cut in the reserve requirement ratio," said Jonathan Fenby, from Trusted Sources.

Mr. Xi is targeting jobs. So long as unemployment stays near 5%, the Communist Party seems willing to tolerate lower growth. "The labor market is still tight. There is a shortage of skilled workers," said Mr. Fenby.

The Politburo removed all reference to targeted easing after its latest meeting this month, instead talking of a "new normal" focused on the quality of growth rather mass production for its own sake.

China’s primary tool for regulating the economy is the quantity of credit, not the price of credit through interest rates. There is little sign that key lending curbs are being lifted. Large parts of the shadow banking system are being shut down, a net tightening of $250bn since June. New loans fell from $170bn in September to $107bn in October. "We’d be surprised if there was an acceleration of credit," said Mr. Williams.

While last month’s rate cut has lifted animal spirits, it does not add much stimulus, or mark a change of direction. It merely slowed the pace of tightening.

Companies have been asphyxiated by a relentless rise in the real cost of borrowing, which has soared from zero to 5% since 2011 due to the effects of falling inflation. Tao Wang, from UBS, said the interest burden for non-financial companies has jumped from 7.5% to 15% of GDP over the same period.

Any Xie, from Caixin, says it will be impossible for China to deflate its epic bubble painlessly. He says house prices will fall by half from their peak in 2011. Massive bad loans in the banking system will have to be written off. "China must stop the debt-capacity spiral. Continuing it provides no way out," he said.

The actress Bette Davis had no idea that her most famous line in pictures, from All About Eve in 1950, would be so apt for Chinese in 2015:  "Buckle your seat belts – it’s going to be a bumpy night."

Ambrose Evans-Pritchard is the International Business Editor of the London Telegraph.

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