China Investment Strategy: How to Bet Your Home on the Stock Market!

I found it difficult to stop laughing long enough to type this story after reading a terrific article that appeared in the Financial Times recently. To find clear anecdotal evidence that Chinese mainland stock markets may be overheated, you need not go any further than the delicious headline: “Chinese bet the house on shares going through the roof”!

In this article, Geoff Dyer explains that China’s pawnshops are doing a land-office business these days, extending credit to Chinese homeowners who are perfectly willing to put up their dwellings as collateral for money to invest in the booming stock market.

Yes, you read that right!

You Bet Your House ...

Three years ago, state-run pawnshops in urban Chinese cities such as Shanghai began accepting houses and apartments as collateral to make consumer loans. At first, customers wanted fast access to this unconventional source of cash to fund start up business enterprises amid the booming economy. But lately, pawnshop patrons have turned to hocking their homes to raise funds for stock market speculation instead.

Retail stock market investment in China is booming, with nearly 1.4 million new brokerage accounts opened in the month of January alone. And all this red-hot trading capital must come from somewhere.

According to official China Securities Journal reports, Beijing homeowners extracted Rmb1.5 billion in 2006 by hocking their homes – and it seems that much of that cash was directed into mainland stocks – which helps explain the 130% gain in the Shanghai Index last year.

Pawnshops Prosper on the Household-Carry-Trade

Do you remember how commentators expressed worry about all the home-equity extraction that took place in U.S. housing over the last few years? Well the financial ingenuity displayed by the Chinese puts us to shame!

China’s pawnshops for their part make good money on this household-carry-trade. They charge a monthly interest rate of 2.5% to 3% -- that’s an APR of up to 36% annually, for those of you doing the math at home. But what’s 36% annual interest when the stock market jumped 130% last year!

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The reality is that the retail investment industry inside China is still a rigged game, with the house in control of almost everything. Far from freely functioning markets in the western-capitalist sense, the government runs the whole show in China. The People’s Party still hold majority stakes in most of the big banks and public companies that trade on the Shanghai and Shenzhen stock exchanges. The government also owns most of the big brokerage houses, they regulate the stock exchanges, and they even control most pawnshops.

The "House" Advantage Goes to the People's Party

As such, the state has in effect sanctioned this sort of speculation, and Chinese authorities also have a vested interest in keeping the whole game going. But they also have ultimate responsibility for keeping the game from getting out of control too. I’m not sure what your definition of “speculation” is, but watching retail investors hock their homes to bid up mainland IPO share prices more than 100% in a day? This seems to me like a textbook sign of speculative market frenzy in the making.

To help restore order, the Chinese authorities could easily raise interest rates at local banks, to make the pitiful yields available on Chinese savings accounts more attractive. This should have the desired effect of cooling speculation in stocks.

Perhaps the government is afraid to take such steps, because the resulting liquidity drain might quickly get out of control in the opposite direction and hammer the stock market as an ugly unintended consequence.

Chinese Stocks for the Long-Run

The real long-term solution is for the government to loosen its stringent capital controls on domestic financial markets, in order to level the playing field for global investors to participate. This should ultimately result in deeper, more liquid capital markets that can function without so much state-sponsored orchestration.

But for now, it’s up to China’s party bosses to try as best they can to manage the fast-growing mass of fickle individual investors throwing money into stocks -- a very difficult undertaking indeed.

Perhaps the recent 15% correction in mainland China shares has run its course after just a few weeks of profit taking, or maybe it’s the beginning of a deeper slump, only time will tell.

But one thing is clear; considering the rampant signs of speculative excess in Shanghai and Shenzhen -- investors with holdings in these markets should be fully prepared to stay invested for the long run.

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[gowri]

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