Should China's central bank buy local equities?

For months now, China's authorities have tried to stop its economy from slowing down. But despite slashing the amount of cash banks must hold as reserves, cutting taxes and encouraging lending to small and private companies, these efforts have so far yet to show up in the economic data.

Chinese consumers continue to cut back spending, with car sales falling for the first time in three decades. Retail sales have also shrunk, along with industrial profits. While the services sector has more or less held up, manufacturing growth has collapsed. The most recent reading of manufacturing PMI slid below 50 last month, indicating a contraction.

In light of this, China-watchers have urged the government to take more aggressive action to prop up growth. One recent suggestion is for the central bank (PBoC) to step in and snap up Chinese equities. But buying up stocks may not be the best idea, and if China is in need of other stimulus tools, there's room on the fiscal front to do more.

For Jim McCafferty of Nomura, though, China's stock market -- which has a market capitalisation of roughly $7.7tn -- is a valuable domestic policy tool at the central bank's disposal. In fact, he argues that "a policy aimed at stimulating the retail-owned stock market would be much more effective at stimulating domestic consumption than the construction of another railway line."

For one, points out McCafferty, more than 90 per cent of the stock market is held by domestic investors. Gains accrued, then, would benefit the population as opposed to international investors, he says.

The market is also fundamentally cheap given its underrepresentation on global equity indices. China's weighting in the MCSI All-Country World Index sits at a minuscule 3.5 per cent, despite the country representing 15 per cent of the world economy. In light of this and MSCI's indication in September that it may increase the weight of China's A-shares in its indexes, McCafferty believes the country's equity market will soon be "too big to ignore".

What is more, many listed Chinese companies have solid balance sheets and understand the importance of keeping shareholders happy. Take China Mobile. The state-owned telecommunications company has a cash balance of more than $70bn and was the largest single dividend payer globally in 2018, according to Nomura. It also actively buys back shares from investors.

Parts of the Chinese government are already active in the country's equity market. For instance, the State Administration of Foreign Exchange controls roughly 3 per cent of the A-share market, per McCafferty. And further afield, there is precedence to do more so. The Japanese government owns roughly 4 per cent of its local equity market. In Korea, the state owns about double that.

The picture that McCafferty paints is a compelling one, but there are several counterpoints to consider. Domestic buyers may dominate the market, but only a fraction of residents overall are poised to reap any benefits. According to figures published in the China Securities Depository and Clearing Corporation Statistical Yearbook for 2017, there are roughly 134m retail investors playing China's stock markets. That's less than 10 per cent of the total population.

Volatility is another concern. According to Victor Shih, a political economist at UC San Diego, the PBoC buying up local equities is "totally inappropriate". The whole point of foreign exchange reserves, he says, is to invest in stable and highly liquid global assets.

Chinese equities are not typically known as beacons of stability. Last year, the MSCI China Index lost 21 per cent of its value, following a 51 per cent gain in 2017. It's not the first time the index has seen such sizeable swings. In 2011, it lost 20 per cent before gaining it all back in 2012.

Nor do Chinese equities have ample liquidity. Here's a chart from David Cui, the head of China equity strategy at Bank of America Merrill Lynch, which shows A-share turnover. Higher turnover points to higher liquidity and an easier time buying and selling stocks.

Unlike McCafferty, Cui believes China's stock market can overcome its shortcomings only if the government intervenes less. In fact, it is because of this intervention that Cui thinks direct participation remains narrow and liquidity lacking: "government intervention, or at least the perception of it, never allowed markets to reach equilibrium levels driven by the commercial positions of investors." The IPO market also remains small as a result of this. Here's a chart showing the amount of funds raised through public offerings, per Cui:

Former PBoC official Sheng Songcheng agrees that the central bank should not buy local stocks. In an op-ed in Caixin Global, Songcheng and analyst Shen Xinfeng write that "the PBoC has no reason to undertake such an endeavour". For one, they say that central bank purchases would intensify stock market volatility and thus distort prices:

Retail investors account for a relatively large portion of China’s stock market and tend to adopt a herd mentality — buying when prices are going up and selling when prices are falling — which aggravates market volatility. If they followed any direct purchases by the central bank, that would create greater fluctuation and disrupt the market’s price-discovery function.

Like Cui, they also believe a healthy stock market will come from more reforms and opening up, not less.

So if not via the stock market, how then should Chinese officials stimulate the economy? Oxford Economics' Louis Kuijis forecasts that the country's headline fiscal deficit will remain around 3 per cent in 2019, although this excludes any activity taken by local government investment vehicles and the like. As well, general government's debt-to-GDP sits around 50 per cent. Rather than the central government, it is corporations and local governments that have the biggest debt woes.

Evidently, China has more room on the fiscal front to shore up growth. Perhaps the government should consider increasing social expenditures like public health spending or raising the minimum pension benefit, as the CFR's Brad Setser suggests, before it tugs on other levers just yet.