China's capital market faces challenge of shrinking population

China's A-shares market was off to a dismal start in 2024 and remained sluggish at the start of February in the lead up to the Lunar New Year. The Shanghai Composite Index hovered around the benchmark level of 2,700 points and hit a five-year low on 5 February, sending market sentiment to freezing point. Since hitting a peak in 2021, mainland China and Hong Kong stocks have lost over US$6 trillion in market value.

Chinese officials have been making several moves recently to boost confidence. Central Huijin Investment Ltd. announced on 6 February that it has increased its investment scope of exchange-traded funds (ETFs) and that it fully recognises the current market allocation value of A-shares. It pledged to intensify its efforts to increase holdings of ETFs, expand the holdings scale, and resolutely safeguard the stable operation of the capital market.

That same day, a China Securities Regulatory Commission (CSRC) spokesperson said that it will firmly support Central Huijin's efforts in increasing holdings and expanding the holdings scale, and also create more convenient conditions and smooth channels for its market operation.

The CSRC also stressed that it would ramp up the strength of supervision and law enforcement, and safeguard the stable operation of the market. Previously, the CSRC asserted that it would ensure that those who dare to illegally manipulate the market and the malicious short sellers will "lose their shirts and rot in jail".

Thereafter, Wu Qing, nicknamed the "Broker Butcher", was appointed as chair of the CSRC, sending signals to the market that more efforts will be directed at strengthening financial regulation and maintaining market order.

Boosted by the slew of good news, on 6 February the Shanghai Composite Index rose a whopping 3.2% - the biggest one-day gain since March 2022 - and the CSI 300 increased 3.5% - the biggest one-day rise since November 2022.

However, I am not optimistic about the future of China's capital markets because the country's present securities market is not only fraught with longstanding habits that are difficult to overcome but also new and emerging issues.

The old problem lies in the fact that reforms have been unable to overcome the systemic challenge of merely treating the symptoms but not the root cause.

While it is clear that the rule of law is the cornerstone of capital market development, window guidance (informal policy instruments to guide financial institutions to extend credit and allocate lending) is unfortunately prevalent in China.

Moreover, stabilising investor expectations and injecting new vitality into the market when the market is volatile can hardly be achieved by appointing a new official, much less shouting slogans.

The new problem lies in demographic changes that have a profound impact on capital markets. This can be explained by the Life Cycle Theory of Savings developed by Franco Modigliani, an Italian-born American economist who received the Nobel Prize in Economics in 1985.

Based on the theory of consumer behaviour in microeconomics and the study of individual consumption, Modigliani's theory is premised on the following assumptions:

First, consumers are rational and can spend their income rationally; second, the only goal of consumer behaviour is to achieve total utility. Thus, consumption is not dependent on current income but on lifetime income.

Modigliani believed that rational consumers will plan their spendings and savings over the course of their lifetime such that their lifetime income will be equal to their spending.

He argued that each household plans their spendings based on their expected lifetime earnings, that is, each household's spending and saving decisions at each point in time reflect the household's attempts at achieving the desired distribution of consumption over the life cycle in order to maximise lifetime utility.

Thus, household consumption is determined by the total income and assets they acquire over the course of their lifetime. In this way, spending and saving is dependent on a household's life cycle phase.

Modigliani divided an individual's lifetime into youth, middle age and old age. Generally, during an individual's youth, household income may be low but there is an expectation that future income will increase, which is why people tend to spend the majority of their household income during this period, sometimes to the point of taking on debt, spending beyond their means.

When they reach middle age, household income increases but spending reduces, and income exceeds consumption. This is because they are paying off the debts accumulated in their youth on the one hand while saving up a portion of their income for retirement on the other.

In old age, income reduces and consumption exceeds income again. Thus, the relationship between income and consumption and between spending and saving changes at different life cycle phases.

Therefore, the life cycle theory of savings further argues that in the absence of significant changes in demographic composition, the households that form society will be at different life cycle phases, and the marginal propensity to consume will be stable in the long run; the relationship between consumption and disposable income, as well as real GNP, will be stable as well.

However, if society's demographic composition changes significantly, the marginal propensity to consume will change as well. For example, if the proportion of youths and the elderly increases, consumption will rise; if the proportion of the middle aged increases, savings will increase.

Applying this theory to the capital market, we can conclude that once the generation with the largest population reaches middle age, they will definitely drive capital markets such as the stock and property markets. This argument is corroborated by empirical research.

Using data from 1950 to 1992, finance professors Gurdip S. Bakshi and Chen Zhiwu argued in a paper they jointly wrote in 1994 that there is a substantial relationship between the average age of the US population of persons 20 and older and the Standard and Poor's 500 Index.

This is because baby boomers bought a variety of savings products such as stocks, property and bonds when they entered middle age to prepare for retirement, thus generating a high demand for such products and in turn driving up the prices.

At the same time, baby boomers' consumption of existing goods and services also contributed to stock market booms. This is based on the theory that the growth of the real economy implies a high level of corporate earnings. Conversely, when the generation with the largest population enters old age, demand for the aforementioned saving products will also plummet. 　　

Unfortunately, China's demographic dividend is vanishing and it is experiencing a profound demographic shift. In the 41 years from 1949 to 1990, China experienced three fertility peaks: 1950-1957, 1962-1971 and 1980-1990.

By 2022, among the two largest generations of people, those born during the first fertility peak have already entered old age. The people born during the second fertility peak are also getting older. Based on the life cycle theory of savings, it is expected that as China's ageing level deepens, the country's capital markets including the stock and property markets will inevitably come under pressure as well.

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