Market Views | Negative bets on China shares may be unwise

Despite the correction last week and the crazy volatility, the recent rise in China’s Shanghai Composite Index is good news for the over-levered companies fortunate enough to be listed on the A-share market.
It is even better for local investors who have piled in, often with borrowed money. In the long term, though, it is not clear whether it will be good or bad for the many foreign funds that have been either short the market or out of it altogether.
There may be worse pain to come for these investors.
On June 9, the MSCI will decide whether to include China in major benchmark indices. Since the last yearly review on the matter, much has changed. At that time, the MSCI decided against inclusion because of the difficulty foreign investors had in accessing the market. But with the Shanghai-Hong Kong stock connect scheme and Beijing’s decision to dismantle capital controls in both directions, the argument in favour of inclusion is more compelling now.
Recent developments in China provide evidence that the surge in the equity market has Beijing’s backing. By cutting interest rates three times in six months, with more expected to come, the People’s Bank of China is encouraging flows into the equity market. So far, retail investors have been the driving force behind this rally. That the authorities are allowing these investors to use borrowed money for share purchases is further indication that the buying is in line with official policy – at least within limits.
Moreover, by raising new equity, companies can use cash inflows to repay their debt at a time when the real cost of debt has risen as inflation has yielded to deflation, making the cost of servicing this debt more burdensome. Deleveraging will help improve profits, making corporate China healthier.
Beijing used to obsess about the social fallout when share booms turn to busts, as they have invariably done in the short 25-year history of the market. In the past, Shenzhen saw riots in the street when the market crashed. This time, fears about unrest seem to have been suspended. Perhaps that is because the authorities expect more foreign money will soon be forced to come in.
Today, many hedge funds are bearish on China, citing slowing growth, as China struggles to adjust to higher labour costs, the end of the low value-added manufacturing for export model, excess capacity in sectors including cement, glass, and steel, and huge ghost developments in places nobody wishes to live.
They are particularly pessimistic about the banks given their massive (though minimally recognised) bad debts and the property companies that have borrowed US dollars, which they may not be able to repay.
But negative may not be wise because these days going short China shares means taking on the central bank itself.
“China is embarking on a pre-emptive easing cycle,” says one Singapore-based investor. “They are aggressive and they have many tools.”
The central bank is not undertaking quantitative easing. To its credit, its policy is not about directly encouraging asset price inflation whether in shares or in property; it is more about stabilising prices and stimulating the real economy. Nor is China making the mistake of only relying on monetary policy – fiscal stimulus is also part of the plan.
The PBoC wants to bring down the price of money (which may have the indirect benefit of stemming the rise in the renminbi) and to direct credit to smaller companies that are still starved of funds. Still, asset prices also respond to lower rates. Already there are signs that the property market is beginning to recover, as transactions increase and prices stop falling.
This is a tough time for underweight foreign investors because the market is no longer cheap. […] But is the underweight now justified?
The motto of mainland investors has long been that he who does not believe in the greater fool theory is the greatest fool. This time, the uneducated punters may actually be right – at least for a while. This is not an easy time for fundamentally driven investors. Henny Sender, Financial Times
MDT/FT Exclusive