China's stock wobbles may deter foreign investors - for now

The rollercoaster movement of China's stock indexes in the recent month has raised eyebrows worldwide, including analysts and portfolio managers in Europe.

Market experts say margin financing – using borrowed money to trade shares, enabling traders to place greater sums in the equities market - and the accelerated pace of initial public offerings have both contributed to the volatility of China's A share market.

"The original move up in the markets was much too fast to be sustainable, particularly since it was largely fueled by leverage. An additional factor was the government's IPO pipeline which was putting way too much supply into the market and causing significant volatility even when the markets were still rising by sucking equity out of the markets in the form of IPO deposits," said Robert Davis, a Brussels-based senior portfolio manager at NN Investment Partners,

Davis added that once the government, through the China Securities Regulatory Commission, warned on margin trading and speculators tried to start selling their positions to lock in their gains, the markets really started to wobble.

Hu Jing, investment manager at Arbuthnot Latham & Co, a private bank in London, echoed Davis's view and believes that an imbalanced client base in China's stock market is also a result of recent market turbulence.

"Retail investors account for around 30 percent of the overall investor base, contributing to as high as 85 percent to 90 percent of daily turnover from time to time. Due to the lack of investment knowledge, the herd behaviour among retail investors is significant and it magnifies any reasonable market movement." Hu said.

Hu explained that market volatility can also be amplified by the fact that the Chinese financial system is still in its embryonic stage and it naturally presents imbalances and limited investment options.

"The main channels for investments in China have been equities and properties. With properties looking lackluster and the bond markets immature, the stock market becomes overcrowded which increases the price sensitivity. The high savings ratio in China is not only a local tradition but also implies the lack of investment channels in the economy," Hu said.

A 30 percent fall in the stock market after a 150 percent surge has meant many Chinese stock investors have suffered losses after making initial gains. Analysts say valuations are always important when buying shares in a company.

"Just trading on momentum and ignoring fundamentals can work for a while, but it will always turn and without valuation support you will end with a crash," said Davis.

"Retail investors have to understand that investing in the stock market requires professional knowledge and experience. Blindly entering an order based on rumours around is highly unreliable and unrewarding, especially for those that have a significant portion of their wealth in equities," said Hu.

Despite Chinese regulator's efforts to improve its financial market over the years, the A-Share market remains some way from being an efficient discounting mechanism of future corporate profitability, according to Douglas Turnbull, Fund Manager at Neptune Investment Management, a UK-based fund management company.

"Rather, it remains subject to retail investor sentiment which can be led by, amongst other things, direction from the government, the liquidity environment, and the relative attractiveness of other Chinese asset classes and investment options. In other words, caveat emptor," Turnbull added.

The Chinese government should keep encouraging more institutional investors to participate in the market, both domestic and foreign, to help guide the local financial market to become a healthier and more balanced investment environment, according to Hu.

"It is important to note that Chinese pension funds' assets total over 2 trillion yuan and legislation is under way to give them permission to allocate into equities," Hu adds.

In an attempt to buoy the market, CSRC has announced a string of supportive policies, including a 30-perecent transaction fee cut, benchmark interest rates and required reserve ratio cut, margin trading rules relaxation and the latest IPOs suspension.

For most long-only market participants, the government intervention is good news as this clearly shows that they are on the investors' side.

"However, in order to overturn the disaster, the government would have to do more, not only injecting liquidity but also making fundamental reforms to allow the financial market function properly. Blindly pumping cash into the system can only postpone a crash instead of avoiding one," Hu commented, adding that "on the other hand, it makes clear to foreigners that the Chinese stock market still has a long way to go before it evolves into a free and ‘investable' market."

But, some fund managers believe it is possible that this very public demonstration of policy intervention in markets might cause a slowdown or even backtracking of wider liberalization and reform.

"This would be extremely damaging for China in the long run as the direction of reform is both necessary and, this episode aside, has largely been well considered. China has serious structural imbalances that liberalization is required to tackle and it would be negative if these were now slowed or watered down," Davis remarks.

Turnbull agreed with Davis saying "The intervention into the market of the government is obviously a step back for financial liberalisation in the near term, but equity market development is only one part of the wider plans being pursued. Hence it is not game-changing to see them feeling compelled to act now out of short term pragmatism."

"Chinese policymakers consistently demonstrate a great degree of skill in controlling gradual change in their economic management. The stock markets seem to be something of an anomalous exception to that, as both 2007/8 and 2014/15 would suggest," Turnbull said.

This episode suggested that insufficient control of leverage on the way up, and insufficient control over the pace of equity issuance, are both to blame for the current market problems, he added.

The volatility in China stock market is likely to make outsiders wary of further exposure to China, as evidenced by Global index provider MSCI last month declining to add China to its global benchmarks.

Whilst speaking of MSCI's future decision on A share inclusion, Davis argued that the suspension of trading of so many A-share stocks is a prime example of government interventions impeding the function of the market, saying it "does beg questions about whether the onshore market is sufficiently mature for inclusion in major global indices."