Audrey Deschenes
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Here’s why everyone needs to care about China’s stock market

(MarketWatch) — It used to be that investors outside China could ignore the gyrations in that country’s stock market, given that no foreign investors were allowed to buy shares. But that’s clearly not the case anymore as declines in Shanghai SHCOMP, +0.20% and botched circuit-breaker curbs helped push the U.S. Dow Jones Industrial Average DJIA, +0.32% to its worst four-day start to a year on record.

One explanation for the severity of the reaction is that it brings to the fore a worry most investors would rather not think about — Beijing is no longer really in control of its equity markets, currency and the world’s second largest economy.

This latest policy misstep again exposes a fundamental contradiction with the ruling communist party: it wants to liberalize markets and access capital but only if it can control the direction of prices. This conflict is proving harder and harder to square away.

For now China has abandoned its experiment with new circuit breakers that triggered the wider panic. As Nomura comments, the circuit breakers were well-intended but functioned as “super-charged accelerators” for investor fears and market volatility.

Chinese Stocks Make a U-Turn

Chinese stock markets recovered Friday after a tumultuous week. But the WSJ's Andrew Peaple explains why few expect the relative calm to last.

Knowing the market might close, investors were rushing to sell, leading to a mere 15-minute trading session on Thursday.

Part of this is due to obvious technical problems in the design. While a 7% fall in the benchmark index lead to trading being halted for the whole day, in the U.S. a similar move would only trigger a 15- minute halt and full-day suspension needs moves of 20%.

China already has 10% daily limits up or down on individual stocks, which are regularly reached. Any circuit breakers should have taken into account the volatility in a market when some 90% of investors are retail and the market prohibits intraday trading.

Removing the circuit breakers helped calm Friday’s trading with Shanghai shares finishing up 1.95%, but it is still a temporary fix.

Chinese equities remain an artificial market and vulnerable to further falls given restrictions on selling and substantial government ownership from last summer’s intervention.

Authorities have now promised more of the same. The ban on large shareholders selling has been extended and the government is back in the market buying.

The stock overhang remains even if it has been pushed out; will these stock owners ultimately be forced sellers or will they just decide liquidity restrictions make equities as an asset class too risky?

The resilience of demand where the government and the so-called “National Team” is the main buyer is the other risk to the market. Buying fatigue is likely if losses continue.

This intervention has also left a dysfunctional market where investing is simply knowing which day or stocks the government is buying, meaning many investors, particularly institutions cannot participate.

A key reason China’s stock turmoil has such a global impact is it is now coinciding with capital outflows and currency weakness. In fact, the beginning of large fund outflows can be traced back to the controversial stock intervention last summer, where Beijing’s attempt to coerce markets faced widespread criticism.

Beijing is now walking a delicate path, as the more expectations grow of currency weakness, the greater the risks of a stampede in capital outflows. And today China’s currency markets are much more plugged into global markets than its stock indices after efforts to internationalize the yuan USDCNY, +0.1645% , meaning the potential contagion here is more obvious.

This week it was revealed that China’s foreign reserves fell by a record $108 billion in December, reinforcing worries that capital outflows are worsening as spending by the central bank to support the yuan increases.

While China still has $3.33 trillion of foreign reserves, the concern is how long it can continue intervening if capital outflows stay elevated. To give some idea of the strength of capital outflows, they have come despite China still running surpluses on its balance of payments and foreign direct investment.

The problem for policy makers is outflows are hard to control, as it let so much foreign capital in during the good times when the policy-driven yuan pegged to the greenback was a safe-haven. Last year Daiwa Research estimated the “carry trade” into China could be some $3 trillion. So far at least China’s offshore bond markets have proved resilient despite equity falls, which would be an indicator of greater unease.

For investors, policy uncertainty looms large so long as it remains obvious the current path being steered by Beijing is not working. China cannot reflate its economy or stock market if money outflows continue accelerating.

Here global markets would have much to consider. The policy prescription would be a sizeable one-off devaluation of the yuan, potentially sparking a new round of destabilizing currency wars.

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