1. SAMPLE ARTICLE
China’s Stock Market Rally Still Has Legs
Long-term value investors loathe Chinese stock market’s current detachment from
underlying fundamentals. The Shanghai Composite has risen by more than 140% in twelve
months while Chinese GDP growth is slowing. Valuations seem overstretched by any
measure. The Shanghai Composite and ChiNext trade at 24x and 146x their reported
earnings, respectively. Yet as with all bubbles, it’s painfully difficult to time a reversal in the
market’s fortunes. In China’s case, prospects are more blurred due to government’s overt
blessings for the rally. But, has the rally run of breath? Probably not.
Bubbly markets and fears of a crash are not unprecedented in China. The Shanghai Composite
climbed several folds in 2007 before it suffered an excruciating plunge in early 2008, leaving
many investors bankrupt and dreams shattered. As earlier, retail investors are in hordes this
time too but unlike in 2007, the current euphoria is being partly fuelled by excessive margin
financing. Margin financing, the practice of using borrowed money to invest in securities, was
prohibited before 2010 in China. A pilot program was launched in 2010 and margin financing
was in full swing by October 2011. Since then, punters have leveraged on this facility and
pushed stock valuations to inflated levels. Worryingly, Chinese brokers are helping sustain
the frenzy. They have raised $9.5bn in equity capital in Hong Kong this year and most of the
new funds will be channeled back into financing more margin loans (Hughes, 2015). Sky-high
valuations encourage more equity issuances by brokers and fill a larger pool available for
margin financing; a vicious cycle is in motion. So the government should surely seek to rein
in, right? Not yet.
State run media have made no secret of their support for the market’s trend. They openly
encourage investment in stocks and rather act as good old financial advisers. Troubled state-
owned enterprises (SOEs) stand to benefit from bloated market capitalizations, setting them
up nicely for restructuring and acquisition strategies in the future. It’s part of the central
government’s love affair with state- owned projects. As local banks begin to tighten their grip
on insolvent private companies, the government wants relatively more relaxed flow of funds
from banks towards sinking government projects. A quick yet dangerous fix is to artificially
prop up valuations of the debt-laden enterprises, making them appear stronger than before,

2. at least on paper. This practice nonetheless makes some economic sense if the SOEs modify
their capital structure by paying off debt with newly issued equity.
Simultaneously, investors have placed bets on continued support from the monetary side.
The People’s Bank of China has already cut interest rates three times in six months, helping
elevate asset prices across the board. With economic indicators signaling more slowdown in
the future, the market expects continued support from PBOC. The Shanghai Composite briefly
fell by 6.5% in late May after news emerged that brokers were cutting back on margin
lending. As of this writing, the index has staged a decent comeback. Buying resumed after
China’s purchasing managers’ index for the non-manufacturing sectors registered its lowest
point since the depths of the financial crisis in December 2008. This trading pattern is eerily
similar to that of U.S. markets during QE’s reign when bad news became good news for stock
markets. At least from this angle, China is not alone at a time when central banks around the
developed world are engaged in some form of monetary easing. In all cases, easy money
policies are highly positively correlated with stock prices.
Interestingly, more is yet to come to the rally’s aid. On June 9, MSCI is set to decide on the
inclusion of Chinese A shares in its global emerging markets index from May 2016 onwards
(Chan, 2015). At the moment, only Chinese stocks listed in Hong Kong are included. MSCI
looked away from A shares the last time but record high capitalizations make a stronger case
this year. The MSCI emerging market index captures large and mid-cap representations
across 23 emerging markets and is tracked by funds worth roughly $1.7trn. If welcomed in,
A shares would receive an immediate boost since funds managers tracking the index would
have to realign their portfolios with changes in the benchmark.
It’s a dangerous game of expectations and as in all bubbles, the participants are riding their
luck to get ahold of the greater fool. And similarly to “irrational exuberances” of the past, it’s
impossible to identify that exact moment of reckoning. One matter is for sure: China’s deep
coffers would surely help the economy withstand any eventual crash. Dance until the music
stops.

3. References
Chan, R. (2015, May 1). China’s A shares seen joining MSCI index, but uncertainties lurk.
Retrieved from South China Morning Post:
http://www.scmp.com/business/markets/article/1783162/chinas- shares-seen-joining-
msci-index-uncertainties-lurk
Hughes, J. (2015, May 24). China brokers’ capital rush fuels margin-fed rally. Retrieved from
FT.com: http://next.ft.com/4094a940-01f9-11e5-82b9-00144feabdc0