Here’s one glaring problem with China’s epic stock rally

Reading between the lines.
Reading between the lines.
Image: Reuters/China Daily
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It’s a common these days to hear that Chinese stock markets are “divorced from reality.” As 2015 has worn on, the economy seems to have slipped into ever more dire straits. China’s stocks, meanwhile, have consciously uncoupled so aggressively from that “reality” that the Shanghai Composite index is up nearly 40% this year—even after its recent precipitous slump.

Weirdly enough, the latest sign of this trend comes from economic data that isn’t dire at all. In the second quarter, China’s economy has undergone a “broad-based recovery,” says China Beige Book, a Beijing-based research group, whose findings are based on surveys of 2,000 firms and interviews with senior management.

It would make sense that the stock market boom, which has allowed companies to raise new equity capital to spend on expanding their businesses would have a lot to do with that revival. But, nope.

“Of all of our indicators, it is capex that should respond most positively to the boom in equities prices,” said CBB’s report, “yet capex saw only a minor uptick, as did loan demand.”

The recovery was instead due mainly to a pickup in sales, particularly to governments and businesses. In other words, the equity boom doesn’t seem to be influencing companies’ decisions to borrow or spend.

So what might firms be doing with the new funds raised from eager Chinese investors?

They might be using these funds to pay off debt, says CBB—something good for China’s long-term financial health. But it might not be so great in the short term if makes capex keep falling, says CBB. Plus, it leaves the economy all the more vulnerable to a sharp drop in the market. If the recent crumbling in share prices keeps up, it could make companies even less willing to invest in building their businesses.

However, it’s not just publicly listed Chinese companies that seen hesitant to spend. In a bid to make banks want to finance firms’ capex plans, the government has been furiously cutting interest rates and reserve requirement ratios—to no noticeable avail. “The main factor limiting private sector investment… is not the credit supply-side but firms’ bleak view of the demand outlook,” wrote Thomas Gatley and Andrew Batson, economists at research group Gavekal, in a recent note.