Could Chinese Market Turmoil Cause a World of Hurt? The Chinese government intervened in its financial markets in July. Will China’s troubles affect the global economy?

It’s been a stressful summer for millions of Chinese stock market investors. The Shanghai Composite Index dropped 32% and lost more than $3 trillion in value in less than four weeks. After hitting bottom on July 9, the market rebounded 15% by July 21 before plunging 8.5% on July 27.1–3

Foreign investors’ access to mainland China’s financial markets is limited by government quotas, but has slowly been expanding. It’s estimated that foreigners own about 4% of China A-shares, the local securities of Chinese companies trading on mainland exchanges.4 This differentiates them from H-shares, Chinese stocks listed in Hong Kong, and N-shares, Chinese stocks listed in the United States.

Still, China is the world’s second largest economy and has trade ties with much of the world. Chinese business activity accounted for 38% of global gross domestic product (GDP) growth in 2014, the largest share of any nation.5

If continued stock market weakness causes the broader Chinese economy to slow further, it could spell trouble for many other nations and the global economy as a whole. Moreover, the speed and depth of the Chinese market’s sudden descent have prompted unprecedented intervention by the ruling Communist Party, drawing attention to the risks that come with investments in foreign markets.6

Behind the Slide

The summer sell-off was preceded by a year-long stock rally that may have become overheated. The Shanghai Composite Index surged 150% in the 12-month period through June 12, and its median stock valuation reached 108 times earnings, even though the pace of GDP growth was slowing and profits were shrinking.7–9

The Chinese stock market is dominated by 90 million retail investors, many from working-class households. The Communist government has promoted stock investing, causing a large number of novice investors to wade into the rising markets over the last year.10

At the same time, margin debt on the Chinese stock market ballooned five-fold in the 12 months through June 12.11 The fact that Chinese investors were buying stocks with so much borrowed money likely made matters worse. As prices fell, more and more investors were forced to sell stocks to repay loans, resulting in a downward spiral.

Life Support

The Chinese government instituted a number of measures to help restore investor confidence and end the sell-off. Regulators tried to encourage stock buying by cutting interest rates, suspending IPOs to preserve liquidity, making loans more available for stock purchases, and allowing pensions to purchase stocks. In addition, a $19 billion stabilization fund was created to help shore up stock prices.12 When prices continued to fall, major shareholders were banned from selling for six months, and a government investigation into short selling was launched.13

Locked Out

Two Chinese market rules impeded trading during the sell-off. First, a daily-limit rule freezes a stock’s share price for the remainder of the day once it rises or falls by 10%. Second, companies can apply for trading halts ahead of major news that might cause their stock prices to fluctuate.

According to a Wall Street Journal analysis, only 3.2% of Chinese stocks were trading freely on July 9; the exchanges allowed about 51% of listed companies to suspend trading, while roughly another 46% of listed stocks were unavailable because of trading limits. Consequently, some U.S.-based money managers whose portfolios follow Chinese stock indexes had difficulty executing trades needed to rebalance holdings affected by market volatility.14

Chinese officials have defended their policies, contending they were necessary to stem an irrational panic that could have damaged the nation’s financial system. Considering that stock indexes were still well into positive territory for the year, some critics think regulators might have overreacted to a steep but necessary market correction.15 Going forward, the threat of aggressive government interference in the markets could have a chilling effect on foreign investment in China.

Financial news out of China and elsewhere in the world could continue to spur volatility in U.S. markets. Even so, it’s generally wise to ignore day-to-day fluctuations and stick to a long-term investment strategy based on your financial goals, risk tolerance, and time horizon.

The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost.

Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to a specific country. This may result in greater share price volatility.

1, 14) The Wall Street Journal, July 21, 2015
2) BloombergBusiness, July 10, 2015
3) The Wall Street Journal, July 27, 2015
4) The New York Times, July 9, 2015
5–6) BloombergBusiness, July 13, 2015
7, 11) BloombergBusiness, July 15, 2015
8) BloombergBusiness, July 5, 2015
9–10) The Wall Street Journal, July 7, 2015
12) The Wall Street Journal, July 5, 2015
13, 15) The Wall Street Journal, July 20, 2015

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. Copyright 2015 Emerald Connect, LLC.