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China Small Caps Crash To Lowest Since 2015 Amid Deleveraging "Selling Panic"

Despite China reporting solid economic data on Monday, with beats across the board in everything from retail sales, fixed asset investment, industrial production and GDP printing at 6.9% and on track for its first annual increase since 2010...

... despite the biggest net liquidity injection by the PBOC since mid June after the central bank injected a net 130 billion yuan, and despite yet another rebound in the Yuan, overnight China's Shanghai Composite slumped by 1.4%, the most since December as a result of a plunge in the small-cap ChiNext index, which tumbled by 5.1%, and is now down 16% in 2017 to levels not seen since January 2015 following a fresh round of broad deleveraging amid concerns about tougher regulations and more IPOs following a high-level conference over the weekend attended by President Xi Jinping in which China hinted at the formation of a "super-regulator".

The good mood from China's data was soured when hours earlier the Communist Party’s People’s Daily newspaper warned of potential "gray rhinos" ; highly probable, high-impact threats that people should see coming, but often don’t, and followed a critical closed-door conference on regulation that will set the scene for the financial sector’s next five years.

For those who may have missed it, over the weekend, China’s 5th National Financial Work Conference (NFWC), which was attended by president Xi Jinping, set the agenda for critical financial reforms over the coming years. At the general level, the five-yearly NFWC held on July 14~15th assigned three main tasks for financial work in next five years:

  • To make finance better serve the real economy;
  • To contain financial risks; and
  • To deepen financial reforms.

Commeting on the meeting, Citi Economics said “we are more positive on China’s financial sector over the next five years — Though less surprising, we believe the key announcements by the NFWC have well captured the critical concerns for China’s financial system. If the measures are effectively implemented under a more unified top leadership after the 19th Party Congress, financial risks would be under better control, leverage levels would be reduced, and capital-account liberalization and RMB internationalism would be pushed forward under a less risky and manageable strategy.”

“Xi’s decision to ramp up the regulatory powers of the PBOC and to establish a commission to oversee financial stability and development reflects the increasing financial sector vulnerabilities in the Chinese financial system,” said Rajiv Biswas, Asia-Pacific Chief Economist at IHS Markit in Singapore. “The Chinese government wants to prevent a financial crisis in China that could create shock waves in the domestic economy and create a rising risk of social unrest."

In practical terms, the conference said the central bank will play a stronger role in defending against risks, and called for more work on safeguarding the financial system and modernizing its regulatory framework. The announcement prompted the selloff in the small cap  ChiNext Index on worries that the government would further intensify its deleveraging campaign, according to Chinese analysts. Quoted by Bloomberg, Zhang Gang, Shanghai-based strategist at Central China Securities Holdings, said that the regulator’s weekend meeting “reflects that China may further tighten the financial market, which has worried investors,” said Zhang Gang, Shanghai-based strategist at Central China Securities Holdings. ““People are rushing to cut risks. ChiNext companies got hurt most from such risk-off sentiment, as many ChiNext firms are highly leveraged.

Others echoed the sentiment: Dai Ming, a fund manager at Hengsheng Asset Management in Shanghai said that Chinese shares are sliding because the government’s National Financial Work Conference showed regulations are likely to tighten. He added that "regulatory tightening concern prompted major shareholders to cut holdings quickly, triggering a selling panic."

As Bloomberg adds, strategists also interpreted discussion at the conference on the need to increase direct financing as a signal that officials may accelerate the approval of initial share sales, diverting investor cash from existing stocks. A Xinhua News Agency statement said China "should increase the proportion of direct financing in total credit." China’s securities watchdog keeps a tight leash on IPOs, with controls on the number and timing of deals creating a backlog of companies waiting for a listing. The regulator approved nine IPOs for a second week in a row on Friday.

“The conference shows regulations are unlikely to ease,” Dai added. “The pace of IPOs has already picked up. So the market is worried if IPOs increase, then demand and supply in the market will be imbalanced briefly.”

Especially hit in the overnight rout were stocks linked to internet finance which tumble on concerns authorities may crack down on the industry.  With the central bank vowing to play a stronger role in defending against risks, investors were concerned that "China may suspend development in some areas including Internet finance due to weak links in regulation so it can better contain financial risk", said Wang Chen, Shanghai-based fund manager with Xufunds Investment Management. As a result, Hithink RoyalFlush dropped by the 10% daily limit, leading sector decline (the company also warned of a profit decrease in 1H and holder’s plan to cut stake), while others slammed included Hundsun Technologies slides as much as 10%, Sinodata falls as much as 9.8% to lowest intraday price since January 2015, Shanghai DZH declines as much as 5%.

Also pummeled were Macau gaming companies on the Hang Seng Index, with Sands China Ltd. and Galaxy Entertainment Group Ltd. retreating at least 2.1%. The catalyst was a research note by Daiwa Capital Markets analyst Jamie Soo who wrote in a research report that Macau casino operators may come under pressure after one of the city’s largest junket operators warned customers and key staff of "liquidity channel impairment, advised clients to withdraw money from affected bank accounts." Meanwhile, offshore Chinese stocks were largely immune to the selling, and were boosted by China's economic data.

Will the rout continue? For now it is unclear, but as Bloomberg summarized the weekend's conference, which it said was "possibly the most important thing that happened in China during the weekend", also said that "many details remain unclear. The most concrete decision out of the meeting so far is President Xi Jinping’s announcement of the creation of a cabinet-level committee to coordinate financial oversight - a task currently divided among four regulators including the People’s Bank of China."

As part of this new potential superregulator, Bloomberg lays out five potential things to watch including i) preventing systemic risk as the "eternal theme" of China's financial framework; ii) the PBOC's role; iii) a more conservative attitude toward financial opening-up, iv) ongoing deleveraging in the financial sector could expand into the broader economy, with the debt of state-owned enterprises as the first priority, and v) the statement said China should "firmly take prudent monetary policy," omitting the "neutral" word top policy makers adopted late last year as they kicked off a nationwide deleveraging campaign. Read more here.