It might look like a bubble – but China’s market could soar still higher

Borrowed money is piling into China, and the stockmarket has all the symptoms of being in a bubble. But as John Stepek explains, it's much too soon to bail out.


Borrowed money is fuelling the bull market

China's bull market is carrying on regardless.

Locals are piling in with borrowed money. The government is piling on the stimulus. One key market has doubled in less than a year.

Is it a bubble? It might well be. Will it burst? Not yet.

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The dangers of using borrowed money to bet on any market

Investors are confident that the Chinese government wants the stockmarket to rise, partly to offset problems in the property market. It's a "state-sanctioned bull run" as one broker told the FT.

So they're using borrowed money to bet big on a rising market. The amount of borrowed money used by long' investors is up 84% since the start of the year, and up around 300% on this time last year.

Using borrowed money to bet on anything is dangerous. In Britain, most people's experience of using someone else's money to bet on asset prices comes from the housing market.

We don't think of it like that, because it's so commonplace in this country. But taking out an interest-only loan to buy your home is essentially a bet that it's OK to borrow more than you can really afford, because inflation and rising house prices will bail you out in the end.

But what if prices fall and interest rates rise? You could be left unable to afford the interest payments. Worse still, the asset you secured the loan against might not be worth what you paid for it. You could get kicked out of the house and left with a big debt still to repay.

Betting on stocks with borrowed money is similar, but more fast-moving. As long as markets go up, you make lots of money, because you're using the broker's cash alongside your own. But if the market falls, then you'll have to cover any losses.

And here's where the comparison with property breaks down. If you own a home that falls into negative equity, it's not actually a problem as long as you don't need to sell and you can maintain your mortgage payments. No one (for a residential property at least) is going to force you to put up a bigger deposit or abandon your home.

If you've borrowed money from your broker and the market doesn't go your way, then you'll face a margin call'. The broker will want you to cough up more money to cover your potential losses. And if you can't do that, your position will be closed and your deposit will be wiped out.

The thing is, all this borrowed money tends to make the market more risky. Because if the market falls hard, and everyone gets a margin call at the same time, then suddenly all those long positions are abandoned. So the market falls further, triggering more margin calls.

You get a cascade effect. A falling market forces more people to sell, which causes the market to fall, and so on and so on.

So it's not the ideal underpinning for any market.

There are good long-term reasons to hang on to China

If China one day wants to have the global reserve currency and I don't think you have to be a raving conspiracy theorist to believe that, this is just part of the emerging superpower shopping list then it needs more people to use it. And that means its markets have to evolve.

Part of that involves opening them up to a wider range of investors, and also allowing their own investors to move their money abroad too. The Mainland-Hong Kong Mutual Recognition of Funds programme has just been launched. As the FT notes, this allows "fund managers to sell Hong Kong-registered funds directly to Chinese investors for the first time."

Secondly, China is also aware that it faces a tricky balancing act in its desire to shift to being a more consumer-centric, modernised economy. And it's more than willing to use plenty of government spending to help it along. The government has just announced big plans for spending on internet infrastructure, affordable housing and new rail plans.

The government has also launched a range of potential public private partnerships worth more than $300bn to build everything from water-related projects to motorways. "The scale of this stimulus will be as large as the previous one [in 2008]," as one broker told the Wall Street Journal.

Finally, while China has already gone ballistic, this could easily continue. My colleague Merryn has written in more detail on the parallels with Japan's mid-20th century transformation and its accompanying bull market and bubble here. One key point is that Japan was similarly under-owned by foreign investors, despite its rapidly increasing importance in the global economy.

The short version is hang on to your Chinese stocks. Plenty more people are going to be scrabbling to get hold of them.

We'll be discussing this and many other topics at the MoneyWeek conference. It's just overtwo weeks away now so grab your seat today if you haven't already.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.