China’s market meltdown has traders rushing to buy protection

15 March 2022 - 09:07 By Sofia Horta e Costa
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While China’s financial markets have seen bouts of instability before — such as in 2008, 2015 and 2018 — the latest sell-off comes at a time when the nation’s reliance on global capital has never been so great.
While China’s financial markets have seen bouts of instability before — such as in 2008, 2015 and 2018 — the latest sell-off comes at a time when the nation’s reliance on global capital has never been so great.
Image: 123RF/BACHO 12345

Investors in Chinese financial markets are paying up for protection across all asset classes, discounting better-than-expected economic data and Beijing’s assurance it wants to avoid being sanctioned over its alliance with Russia.

Hedging a gauge of Chinese shares is the priciest in at least a decade relative to US equities. Credit-default swaps insuring China’s five-year government bonds are the highest in two years. Options skew in the currency market is at levels last seen in late 2020, reflecting bets the yuan will weaken against the dollar. Outflows from the nation’s sovereign debt show even assets perceived as havens are turning risky. 

Pressure is building on Chinese markets from multiple sources. The government’s crackdown on tech firms and property developers is hurting their profitability and blunting the wealth of their billionaire founders. Decoupling from the US increases the likelihood of forced delistings. A strict Covid-19 Zero policy is resulting in city lockdowns across China as omicron spreads, undermining the economic outlook. Xi Jinping’s close relationship with Russia’s Vladimir Putin risks a global backlash against Chinese firms.

Investors in Chinese financial markets are paying up for protection across all asset classes, discounting better-than-expected economic data and Beijing’s assurance it wants to avoid being sanctioned over its alliance with Russia.
Investors in Chinese financial markets are paying up for protection across all asset classes, discounting better-than-expected economic data and Beijing’s assurance it wants to avoid being sanctioned over its alliance with Russia.
Image: Bloomberg

While China’s financial markets have seen bouts of instability before — such as in 2008, 2015 and 2018 — the latest sell-off comes at a time when the nation’s reliance on global capital has never been so great. Between the start of 2019 and the end of 2021, overseas holdings of local stocks increased by more than 242% to 3.9 trillion yuan ($613 billion). Inflows into the nation’s bond market rose by 129% to 4.1 trillion yuan. The country’s domestic shares were only added to MSCI indexes in 2018.

The loss of confidence by global investors comes at a crucial time for China’s ruling elite. In the autumn, the Communist Party will announce a twice-a-decade leadership reshuffle. Xi is widely expected to extend his rule as party chief and install allies in key positions, while Premier Li Keqiang will step down from his role. 

The pace of selling has been brutal. The MSCI China Index has plunged 23% this month, about four times the loss by MSCI Inc.’s global measure. The Chinese gauge is now down 53% from last year’s peak, a rout only exceeded by the bursting of a bubble in 2007-2008. About $4.5 trillion has now been wiped from the value of Chinese and Hong Kong shares. The yield on Chinese junk debt has surged above 27%. The yuan just had its worst two-day loss against the dollar in two years.

The bull case built on stimulus expectations and cheap valuations is being eviscerated. China’s central bank unexpectedly refrained from cutting interest rates on Tuesday, showing its restrained approach to monetary policy amid increasing inflation risks. Wall Street was overwhelmingly bullish on Chinese stocks when the MSCI China Index traded at 12.2 times projected earnings because stocks were too cheap to ignore, but it’s now valued at only 8.5 times earnings.

The result is the cost to protect against losses is surging. China’s five-year sovereign credit default swaps are nearing 70 basis points, the highest since the early days of the pandemic in 2020. In the corporate bond market, high-yield credit spreads over comparable Treasuries are the widest on record — at nearly 2,600 basis points on an option-adjusted basis, data compiled by Bloomberg as of Monday shows.

The price of hedging Chinese stocks is also reaching extremes. Implied volatility of the $5.1 billion iShares MSCI China exchange-traded fund — the largest US-listed ETF tracking Chinese stocks — is at a record relative to the US stocks ETF (ticker SPY), according to 30-day data. Short selling comprised almost 70% of Trip.com Group Ltd.’s total turnover in Hong Kong on Monday, and almost 40% for Alibaba Group Holding Ltd. earlier this month.

There’s little sign investor confidence will return any time soon. Questions are being asked about the sustainability of China’s Covid-19 Zero policy given the highly contagious nature of omicron, and the impact of the strict approach on the economy. Cities across the country are being locked down as new infections surge. Despite Beijing’s protestations, the nation increasingly risks becoming embroiled in Putin’s war with Ukraine, threatening China’s global standing.

While Chinese authorities vowed to prevent volatility in the nation’s stocks this year, history shows turbulence in the country’s financial markets is hard to calm. With risks rising on multiple fronts, Xi and his officials face a tough struggle to maintain stability in a crucial year.

More stories like this are available on bloomberg.com

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