This supplement provides additional information on developments since the staff report was finalized in mid-June, with focus on the equity market, recent data releases, and monetary policy. This information does not change the thrust of the staff appraisal and paragraph 6 of this supplement adds the staff appraisal of recent developments.
1. The equity market declined sharply starting in mid-June, giving back part of the preceding rally, with ongoing volatility. In little more than a year, the market had risen by around 150 percent through mid-June (see Box 4 in the staff report). It then dropped by over 30 percent in less than three weeks, followed by some rebound after a broad set of measures were implemented to stabilize the market. Despite the correction, the market as of July 17 was still up over 80 percent relative to April 2014. During the decline, many stocks had their trading suspended temporarily as they hit the 10-percent daily stop-loss limit or at the request of the company; at market trough on July 8 over half of listed firms were not trading. In subsequent days, many companies resumed trading and the number of listed firms reported as not trading dropped to about one-fourth of listed firms by July 17. As of July 17, sizable volatility in stock indices and prices of individual firms continued. There was some spillover to the foreign exchange market and Hong Kong SAR markets, albeit limited and short lived so far.
2. The authorities responded with a range of measures to restore orderly market conditions and stabilize the market. Initial steps in the first few days of the correction were perceived by many market participants and observers as poorly coordinated and ineffective. They were then escalated to a broad and powerful set of actions which included:
- Providing liquidity. China Securities Finance Corporation (CSFC), which is the clearing house for margin financing and stock lending, received liquidity with the assistance of the PBC, and provided more liquidity to securities firms; margin rules were relaxed, including by expanding the type of collateral to include real estate, and easing requirements for margin calls and liquidation of margin loans.
- Reducing selling pressure. Twenty-one securities firms pledged not to sell proprietary positions; the regulator set a six-month ban on sales by large shareholders; margins for selling certain futures were increased; and an investigation into suspicious short sellers was started.
- Supporting new purchases. CSFC bought a wide range of stocks; big shareholders of listed SOEs and mutual funds were encouraged to buy stocks; the CBRC supported banks to increase collateralized lending for equity buybacks; and transaction fees were lowered.
- Reducing the supply of stocks. New initial public offerings (IPOs) were temporarily suspended.
Following these actions, stocks stabilized and rebounded starting on July 9, with declining intraday volatility.
Shanghai Composite Index 1/
1/ Black line shows daily high and low of the index. Blue line referes to daily closing price.
3. Even though the market correction was sizable and fast, the economic and macro-financial consequences are likely to be manageable given the available buffers. Wealth effects from past equity price changes in China were small, with only a small portion of household wealth in stocks, and the relative brevity of the preceding rally suggests that it had not yet significantly altered spending behavior. Thus, even if there were a further correction, the impact on consumption would likely be limited. Regarding financial stability risks, while the linkages between securities companies, banks, and the repo market have strengthened, they do not yet appear systemically important. Margin financing had risen fast over the past year, though from a low base; at its peak in mid-June market estimates put it at 4–6 percent of GDP. Since then, it has declined significantly, although further unwinding is to be expected. Securities companies, the sector most exposed to losses from an equity market decline and margin financing, on average have balance sheets strong enough to absorb considerable losses. In addition, since they are a relatively small share of the financial system, they are unlikely to pose systemic risks. Nevertheless, there is some uncertainty about the extent of equity-related lending in shadow banking and the nonfinancial sector. Hence, it is important that the authorities closely monitor—as they are now doing—developments and potential spillovers.
Sources: CEIC; and IMF staff estimates.
1/ Other margin financing is based on market estimate of 0.8 - 2 trillions of RMB.
4. Going forward, the authorities should curtail market intervention, focus on maintaining the liquidity of systemically important institutions and groups of institutions, and strengthen the framework for market regulation, supervision and crisis management. The authorities’ actions signaled their determination to ensure orderly market conditions and prevent excessive volatility and systemic financial risk. However, the heavy intervention created risks exacerbating ‘moral hazard’ (fostering a perception of government support for a market floor), and may raise questions about the system’s and policies’ market orientation. Thus, the authorities’ strategy should now focus on maintaining orderly market conditions and confidence in the stability of the system, without shoring up prices around a particular level. This approach would involve exiting price support mechanisms and restoring price discovery and transparency as soon as possible, irrespective of the impact on price levels. Systemically important institutions (or groups of institutions) may need continued liquidity support in the short term, subject to strict oversight and collateral requirements. Once conditions have calmed, exceptional measures can be removed, combined with further strengthening the resilience of the financial system, would support the goal of maintaining momentum towards a well-regulated, market-based financial system. Improved coordination among relevant agencies, under clear leadership and communication, will be key to effective and swift action in similar circumstances in the future.
5. Authorities’ views. The authorities emphasized that their response was focused on preventing disorderly market conditions and excessive volatility, especially as large-scale unwinding of margin positions risked triggering a negative feedback loop between declining prices and margin calls. Looking ahead, they agreed that market regulation and supervision needed to be vigilant against the build-up of risks, including large margin positions, and expected the exceptional measures applied to stabilize the market to be phased out over time as market conditions permitted.
6. Recent data suggest developments are broadly in line with staff’s forecast. GDP growth in Q2 was 7.0 percent, which is somewhat higher than staff forecast (Figure 1). However, growth in the second half of the year is likely to be somewhat weaker given the headwinds from recent equity market turbulence, which could reduce the contribution to growth from financial services and have some, even if small, impact on demand through wealth and confidence effects. Thus, on balance, developments are consistent with the staff’s forecast for growth this year (6.8 percent) and the authorities’ target of around 7 percent. Headline and core CPI increased modestly in June, while PPI inflation remained negative.
Figure 1.China: Recent Developments
Sources: CEIC Data Company Ltd.; Haver Analytics; and IMF staff calculations and projections.
7. Benchmark interest rates were further lowered on June 28. The one-year benchmark deposit and lending rates were lowered by 25 basis points. As the margin above the benchmark deposit rate remained unchanged (1½ times), the maximum deposit rate fell by 37.5 basis points (to 3 percent). The authorities explained that the nominal rate cut maintained an appropriate level of real interest rates in light of lower inflation. They also noted that credit growth had remained stable, with TSF growth at 12.2 percent (y/y) and M2 growth at 11.8 percent in June. Staff considers, and the authorities agreeed, that monetary and credit developments now appear to be on track toward achieving GDP growth of around 7 percent for the year. Staff therefore considers that monetary policy need not alter its course as a result of recent stock market developments, given their limited systemic or macroeconomic impact. Regarding benchmark deposit rates, staff continues to believe that the time has come to complete the liberalization of interest rates by removing the deposit rate ceiling (staff report paragraph 39).
Sources: CEIC; and IMF staff calculations.
8. Policies following the recent correction in equity markets should aim to restore fully functional market conditions as soon as possible. After a major rally over the past year, the market corrected sharply in a short period of time. Initially less effective, the policy response soon widened to a broad range of measures to restore orderly market conditions and stop the decline. While the market appears to have stabilized for now, the measures reached far into areas that involved the approval of companies’ requests to suspend trading, reducing sales, and boosting purchases of stocks through public entities. This set of interventions needs to be curtailed to permit a return to normal price discovery. Future interventions should focus on restoring orderly market conditions, irrespective of the impact on price levels. The recent episode has also highlighted the need to improve coordination among relevant agencies, under clear leadership, and to communicate policy goals and actions early, clearly, and with a unified voice.