China shares extended their decline with a further 6% drop yesterday, its largest since August 2009 and one that effectively pushes the indices into bear market territory – Chinese shares have decreased more than 20% from this year’s high. The carnage yesterday in particular, was spurred by a lack of relief offered by the People’s Bank of China (PBC) which said that there is a reasonable amount of liquidity in the financial system and urged banks to control risks from credit expansion, instead of offering relief from the cash squeeze on Chinese banks.
 
In a research piece released yesterday, Macquarie Equities Research (MER) ponders if Chinese shares have reached their bottom.

MER’s view on China
MER has no idea where the bottom is for the battered HK China equity markets but states that it surely does not feel like we are there yet. MER applauds the PBC's tough stance on reining in shadow banking with its refusal to inject liquidity into the system. Many investors would agree China maybe on a path to debt induced crisis if the government does not act quickly to deflate the debt bubble and control the rapid expansion of shadow banking products such as trust and wealth management products. The off-balance-sheet products are not only lightly regulated, with very poor disclosure of risks, but also have a massive mismatch in duration between the very short maturity (often less than 3 months) of these products and long duration of the underlying assets (property and infrastructure projects). A liquidity squeeze will eventually happen anyway because of these systemic risks in the current set-up, and the PBC is just proactively trying to pop the bubble before it gets too big to prick without destabilizing the Chinese economy.
 
Why now for the PBC to act? In MER’s view, PBC has perhaps attempted to show the banks how serious the problem is and to show which players may be swimming naked when the tide goes out. Other than the usual seasonal factors, there are two additional catalysts this time around that would make liquidity particularly tight – the crackdown on fake export / import trades, which in turn reduces forex flows into the country, and tougher regulation on wealth management products, which forces banks to place some of their wealth management products back onto the bank' balance sheet. Just when banks need the liquidity the most, the PBC has refused to inject, inducing the most stress in the system and most ‘pain’ on the weaker banks. In addition, often there is a political element in the economic and monetary policy setting as well. It is fair to assume it is the very top of Chinese leadership, not the PBC, who are calling the shorts here. It is to the current administration's benefit if the credit problems get exposed sooner rather than later so they can have a relatively clean plate and move on (up hopefully) from here.
 
What will happen next?Naturally, when access to liquidity is getting tighter, banks and brokers may be the first to feel the impact as they rely heavily on interbank market and short-term financing to run their day-to-day operations. While MER does not expect any bank failures in China, some non-bank financial institutions – such as trust companies and trust insurance companies – may not be so lucky. Once these non-bank financial firms are unable to roll over their short-term liability (maturing trust loans), the retail holders of these financial products may be left holding empty or half-empty bags and some of these institutions may have to close doors forever. After the initial shock waves have hit the financial landscape, impact on the real economy will start to be felt, particularly for those highly geared, as rates may move higher across the board. Highly leveraged industries and companies include commodity trading firms, some cement producers, ship builders and some solar players.
 
How should investors be positioned? MER is advising their institutional investors to be positioned very defensively. One thing coming out of this latest liquidity debacle is that growth will slow down substantially for sure as credit expansion needs to slow and banks are reorganizing their loan books (e.g. lend less to big state owned enterprises more to small medium enterprises; have better designed wealth management products with matching durations between assets and liabilities, etc.). While MER views this as a positive for the government to try to control the credit growth with this latest stunt, the resulted slower growth will prove to be a source of pain for many equity investors. To fly or hide in this environment, MER would stay in defensive sectors such as Gas, Renewable Energy, Consumer Staples, Utilities and Telecom.
 
ChinaA50 Index a proxy to China equity market
The FTSE A50 Index tracks the performance of the 50 largest A-share companies listed on the Shanghai and Shenzhen stock exchange. It includes mega-names like Ping An Insurance, China Merchants Bank and Shanghai Pudong Development Bank. The index gives investors a broad exposure to the China story.

Source: Macquarie Research - 25 Jun 2013