After Quick 8.5% Crash, Confusion Reigns in Chinese Stocks

Tuesday 28th July 2015

by Kyoungwha Kim and Kana Nishizawa

July 28, 2015

It’s days like Monday that reassure Tony Hann he was right to avoid stocks in mainland China.

The severity of an 8.5 percent drop in the Shanghai Composite Index is bad enough, but what irks him the most is not knowing why it tumbled so much. In a market where unprecedented intervention has made government money one of the biggest drivers of share prices, authorities aren’t transparent enough for investors to make informed decisions, said Hann, the head of emerging markets at Blackfriars Asset Management Ltd.

Monday’s plunge was all the more surprising because it followed a government rescue package that had helped drive a 16 percent rally since July 8. That support appeared to vanish without warning, leaving analysts guessing whether authorities shifted their policy stance or just got overwhelmed by a flood of sell orders. After the close of trading, the securities regulator denied speculation that the government has exited the stock market.

Investors “are concerned and lost,” said Alex Wong, a Hong Kong-based asset-management director at Ample Capital Ltd., which oversees about $155 million. “China’s market is distorted, so you can’t sell short very confidently and you can’t buy up very confidently either.”

State Support

Signs of government purchases that were prevalent in recent weeks went missing in Monday’s rout. PetroChina Co., long considered a favorite holding of state-linked rescue funds, sank 9.6 percent. The government-run oil producer had been one of the biggest sources of support for the Shanghai Composite on big down days in late June and early July.

China Securities Finance Corp., a state-backed agency that provides margin financing and liquidity, hasn’t withdrawn support for equities, China Securities Regulatory Commission spokesman Zhang Xiaojun said in a statement Monday. The commission will “continue efforts to stabilize market and investor sentiment, and prevent systemic risk,” he said.

The China 50 ETF, another target of government funds, dropped 9.1 percent Monday. The Shanghai Composite’s one-day selloff was the broadest since at least 1997, with 959 more shares in the index falling than those that gained.

Selloff Risks

If state-run funds withdrew support to test whether shares could stabilize at current levels on their own, the resulting retreat may prompt the government to step back in immediately to prop up prices, said Hann, who oversees about $350 million. On the other hand, if policy makers are starting to unwind support measures to let the market play a bigger role, shares may have further to fall, he said.

“It is impossible to say at this stage,” said Hann, who has exposure to China through businesses listed on Hong Kong’s exchange instead of mainland bourses. Foreign investors have unloaded about $7.6 billion of Shanghai shares through the city’s Hong Kong exchange link since July 6, selling stock holdings for the 13th time in 16 days.

Chinese policy makers have surprised investors before. In 2014, they jolted currency traders who regarded the yuan as a one-way bet by selling the currency and widening its trading band, spurring a record quarterly decline. The year before that, authorities tackled speculative lending by restricting the supply of funds to the banking system. The result was the country’s worst modern-day cash squeeze.

The International Monetary Fund has urged China to eventually unwind its support measures, saying share prices should be allowed to settle through market forces, according to a person familiar with the matter, who asked not to be identified because the talks are private.

Government Operations

“The markets in China now are not really markets,” Donald Straszheim, head of China research at New York-based Evercore ISI, said on Bloomberg Television last week. “They are government operations.”

Policy makers still have firepower to support equities and state-linked firms will probably start buying when the Shanghai Composite falls below 3,800, said Yang Delong, chief strategist at China Southern Fund Management. The gauge closed at 3,725.56 on Monday.

Officials have already banned major shareholders from selling stakes, encouraged government-owned companies to boost holdings in listed units and armed China Securities Finance with more than $480 billion to support equities.

“China won’t tolerate a worsening stock market, so those state-backed financial institutions may start buying,” Yang said.

For Ken Chen, a Shanghai-based analyst at KGI Securities, the more likely explanation for Monday’s tumble is that the government is struggling to prop up overvalued shares. At 66, the median trailing price-to-earnings ratio on mainland bourses is higher than in any of the world’s 10 largest markets. It was 68 at the peak of China’s equity bubble in 2007.

“It’s hard to start a new up move after a bubble bursts,” said Chen. “I don’t think they are able to prevent it falling.”

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