China has struggled to contain the turmoil in its Shanghai and Shenzhen stock markets. Recent falls have also spilled over into Hong Kong-listed Chinese equities, to which international investors have higher exposure. Although there are pockets of potential value in the Chinese market, we continue to make no investment recommendations on Shanghai and Shenzhen stocks and remain neutral on Hong Kong-listed Chinese equities relative to other emerging markets. Heightened volatility means this is not an ideal time to buy in.
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Shareholders on a security trading floor in Shenyang, China.
China's government is used to getting its way. It maintains a tight grip over the currency and can even target GDP growth. But the stock market, it seems, is harder to tame.
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Even after a rebound on Thursday, the Shanghai Composite was down more than 20 percent since mid-June through the end of last week. Equally remarkable, the slide has largely persisted despite numerous official efforts to restore calm.
Rules on margin lending have been relaxed, state-controlled brokerage firms marshalled to buy stocks and short-selling rules tightened – among other measures. Yet instead of restoring calm, the government intervention may have spread the contagion to Hong Kong.
While the Chinese state holds sway over financial institutions, retail investors are difficult to influence. And they account for about 80 percent of the trading volume in the Shanghai and Shenzhen A-share market.
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The challenge of persuading them not to sell has been made all the harder since many have been trading with borrowed money. Such margin lending roughly quintupled over the past year to a peak of $354 billion (2.2 trillion yuan). The government has eased borrowing terms to reduce forced selling from margin calls. But investors trading on borrowed money are likely to be more eager to cut their losses — whether compelled to or not.
Short-selling restrictions also miss the target. Borrowing stocks was already difficult, so short-selling has not played a major role in the market anyway.
Finally, in recent weeks the government lent $42 billion (260 billion yuan) to 21 brokerage firms to support blue-chip stock purchases. In a market where daily turnover can hit 2 trillion yuan, the plan is equivalent to just a few hours' worth of trading. Worse still, to finance this buying, some brokers appear to have been obliged to sell internationally traded H-shares in Hong Kong. That has spread the market infection. Toward the end of last week, MSCI China, which consists almost wholly of Hong Kong-listed shares, was down over 15 percent since mid-June.
One point of comfort is that there is likely to be limited fallout from the slump. For a start, the effect on consumption should be muted. Chinese citizens hold just 6 percent of their wealth in stocks, far below the 22 percent allocation of U.S. households. Historically, there has been very little evidence of a linkage between market returns and GDP. The 70-percent rise in Chinese equities from February through June did little to drive economic activity, so the subsequent 33-percent decline is unlikely to seriously undermine it either.
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The damage to investors should also be contained. Despite the recent plunge, many Chinese investors are still in the black. As of last week, the Shanghai Composite was still up 80 percent over the past 12 months. And there will be limited impact on international investors, since Chinese A-shares account for just 1 percent of equity holdings and H-shares for 5 percent.
We remain neutral on MSCI China. While there is value in some segments of it, including financials and select state-owned enterprises that may benefit from reform, the market is likely to remain volatile. We believe the time is not opportune to increase exposure.
Commentary by Christopher Swann, cross-asset strategist at UBS Wealth Management, which oversees $1 trillion in invested assets. Follow UBS onTwitter @UBS.