China’s investors face a testing year as reform speculation intensifies, says Pete Sweeney of Reuters

Rapid swings in Chinese financial markets in response to ambitious reform plans herald a white-knuckle year for investors, as speculation on the direction and tempo of policy pours gas on an already volatile market.

The conclusion of a key Communist Party conference on economic policy last month put Chinese markets on a roller coaster ride. Stocks dropped 2 percent the day after the plenum concluded, only to change their mind and jump 3 percent just two days later.

Money and debt markets experienced the opposite reaction, with bankers hoarding cash and bond auctions going undersubscribed as investors worried that plans to liberalise interest rates will mean higher borrowing costs.

The sweeping reforms announced last month, touted as the most significant since Beijing first began opening its economy in 1978, risk making already twitchy Chinese markets even jumpier as people try to guess which companies and financial products will benefit - or suffer - from 60 distinct proposed areas of reform extending to nearly every corner of financial markets.

Will loosening restrictions on the one-child policy boost profits for baby product manufacturers? Will implementing a property tax scheme pull money out of real estate into bonds? Stocks? Cash? What's going to happen to listed state-owned companies as they are exposed to greater competition?

"Reform is a painful adjustment, and after 35 years, the reforms that remain are the difficult ones," says Shen Minggao, head of China research at Citigroup in Hong Kong.

"It's not like everyone will be better off; some will be worse off. The only thing regulators can choose is whether to have short-term pain or long-term pain."

Chinese leaders have promised to give markets a "decisive" role in pricing assets throughout the Chinese economy; by doing so, reformers hope to resolve economic distortions introduced by underpriced and misallocated investment.

In the long term, most economists believe this will be a net positive for the Chinese economy. But in the near term, such rebalancing means introducing more downside risks, including into asset classes previously considered one-way bets.

How Chinese market participants react to the reform pain - particularly the relatively unsophisticated mom-and-pop investors that dominate trading volumes on stocks markets - is an area of major uncertainty.

Many have never experienced a recession, never lost money on a housing investment, and have never heard of a domestic corporate debt default; so far, the only market perceived to have a significant downside risk has been the stock market.

And the stock market itself is a wild card. Initial public offerings have been frozen by regulators for a year, which many investors considered a sideways attempt to prop up stock prices for already listed firms.

Once the IPO dam is opened, many fear indexes will plummet on fears the new listings will dilute valuations. And then there's the prospect that China would allow foreign firms to list, competing with local champions for capital, the very rumour of which has caused markets to slump in the past.

The Chinese derivatives market, which would ordinarily provide a diverse suite of risk-mitigating hedging tools, remains a work in progress, with regulators still testing different options contracts in simulated trade.

More to come

Investors were still in a highly keyed up state last month.

Realised volatility for the CSI300 index, which tracks the largest tickers in Shanghai and Shenzhen, spiked to its highest level since a massive cash crunch in June, and remained elevated as of press time.

Money and debt markets are also unstable. Bond auctions by two policy banks last month were undersubscribed, and the official Shanghai Securities News reported that at least 20 corporate issuers had delayed scheduled bond auctions, thanks to weak demand in November.

A massive cash injection by the central bank last month helped smooth the path of another auction by the China Development Bank, but money traders shrugged off the move and pushed short-term rates higher.

Interbank dealers and analysts predicted that current conditions might be the new norm: increased bearishness in Chinese debt markets to the general benefit of stocks.

"We believe the reforms are good for China, bad for credit," Morgan Stanley researchers Jonathan Garner, Wiktor Hjiort and Kewei Yang wrote in a report.

They argued that because state-owned enterprises (SOEs) are the largest participants in Chinese debt markets, reforms to make debt more expensive while increasing competition for these firms will make bonds less attractive in general.

"Policies around market-based pricing, SOE reform and hukou [residency] registration are likely to have the largest market impact and could help reverse a two-year trend of stable credit performance."

Signals

Economists warn that discovering the proper sequence for liberating currency, housing, stock and bond markets will be critical for Beijing if it wishes to avoid destabilising the financial system.

Otherwise, a reform in one market could inadvertently destabilise adjacent markets by provoking investors to abruptly rebalance their portfolios.

Given the strong role the state plays in the way money moves through the Chinese economy, many Chinese investors have rationally focused more on policy winds than on macroeconomic fundamentals, which has made markets particularly sensitive to unsubstantiated rumours of reform or crackdown.

In addition, the markets are increasingly sensitive to each other. For example, part of the reason money markets are tight at present is because of a rally in the real estate market. Explosive rises in housing prices have caused banks to hoard cash, assuming that regulators will attack real estate speculation by reducing the amount of cash in the financial system available to speculate with.

And then there is the final wild card: foreign investment capital flowing across China's border. Economists believe a substantial portion of such flows are seeking to exploit another market - the foreign exchange where the yuan has maintained an inexorable record-breaking rise.

These flows are blamed for pouring fresh cash into the economy, aggravating inflation, but they are also welcomed as an alternative source of funding for Chinese companies. How and when Beijing allows such flows to increase in both directions will also have a major impact on market behaviour.

So far, most investors are taking a wait-and-see approach, says Dariusz Kowalczyk, strategist at Credit Agricole CIB in Hong Kong.

He and other analysts say there was little sign that foreign or Chinese investors were moving to significantly adjust their portfolios based on what they have seen so far.

"The reformers are probably going to disappoint the market overall," he says, pointing to the absence of a stock market delisting mechanism in the plan as a particular area of disappointment.

"Basically, they list goals but they don't say how they are going to be achieved."

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