China’s Failure to Stem Stock Market Debacle Possible Trigger for Financial Crisis, Says Bank of America

Analysts at BofA Merrill Lynch Global Research believe that the recent roller-coaster ride in China’s A-share markets has damaged investors’ faith in the government’s ability to manage asset prices, including the RMB, debt and even property.

“As a result, we expect many of these assets to be re-priced lower going forward,” said the analysts in a new report. “Also, the ripple effect from the market correction has yet to show up – we expect slower growth, poorer corporate earnings, and a higher risk of a financial crisis.”

Behind the Curve

Bank of America questioned the implementation of the policy to urge people to buy stocks. “In our view the government started too late and without adequate preparation for the potential downside (we suspect because it didn't know the true extent of shadow margin financing activities) and it resorted to administrative control when the market turned down,” the report concludes.

The Shanghai Composite Index rose 5.8% by 2 pm on 9 July, erasing an initial loss of 3.8% in the morning. The index has pared 32% of its value since June 12, while the Shenzhen Composite has lost 40%.

In the last two weeks, regulators stopped major shareholders from selling stakes in listed companies and allowed banks to roll over borrowings backed by shares. Trading in nearly 1,500 companies has also been halted, preventing disposals in about 50% of the market.

But, says Bank of America, “so far, government measures have appeared to us to be behind the curve. As a result, we expect investors to assign less value to various perceived government ‘puts’ going forward.”

Trigger for Financial Crisis

One possible consequence may be more caution on the part of government towards quantitative easing, relying instead on the property market or debt market to drive economic growth. But “a burst of any of these bubbles, if fully developed, will be far more difficult to deal with than what's happening in the stock market,” Bank of America warns.

“If the market continues to fall sharply, stock lending related losses could run into RMB trillions, of which banks and brokers may have to bear a meaningful share,” report continues. “These potential losses can be especially dangerous to brokers, whose capital base is less than RMB1 trillion.”

“Even more important, the opaqueness of China's financial system and the lack of clear definition of risk responsibility mean that contagion risk is high, similar to the subprime crisis.”

The report concludes: “We had always considered the risk of a financial crisis in China as high. What has happened in the stock market has likely increased the risks considerably and also brought forward the timeline by our assessment - the leverage is much higher now and economic growth rate, potentially lower.”