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How long can China's 'Rescue Squad' keep intervening?

FRED DUFOUR | AFP | Getty Images

One month after mainland equities started their sharp selloff, Chinese investors continue to look to the government to help stabilize markets—but just how long can officials maintain their support?

Volatility in Shanghai and Shenzhen stocks subsided on Wednesday after a rough start to the week. Tuesday saw markets swing wildly between gains and losses following a precipitous 8 drop on Monday. This week's declines has been put down to local media reports that the government may withdraw the market support measures it announced in the last bout of seesaw trading in June.

But fresh confirmation that officials would remain accommodative has calmed investors down. The China Securities Regulatory Commission announced late on Monday that local governments will increase stock purchases while the central bank injected $8 billion into money markets on Tuesday and hinted at further monetary easing.

"Confidence in China's Rescue Squad was quick to rise this time around because market-boosting measures were already in place, compared to last month when it took a while for markets to believe in the government's defense," said Bernard Aw, IG's market strategist, during a phone interview.

Aw expects the official support program to last for another few months at least, thanks to Beijing's substantial war chest. Capital outflows have been on the rise with June foreign exchange reserves $299 billion lower than last year but that's still a drop in the water of Beijing's total $3.7 trillion reserves.

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He believes Beijing is willing to tolerate a modest correction but certainly not the extent of 8 percent crashes.

But for others, the government's program has no end in sight.

"The government entered the market when it was at high levels, around 30 times price-earnings ratio. There is no exit strategy for them; I think they've become long-term shareholders," Francis Cheung, head of China and Hong Kong strategy at CLSA, told CNBC.

Unless Beijing allows the market to correct to fundamentally supported levels or wait until earnings grow enough to support valuation, the government cannot stop, he warned. "Until then, we expect the market will trade between the government prescribed range of 3,400 to 4,500, the level that they intervened at the low end and the level brokers are allowed to sell stock at the high-end."

China’s margin challenge

Beijing may have the resources to support the market, but that goes against its long-term goal .

A move in early June to curb the amount much brokerages can lend for stock trading, a practice known as margin lending, was aimed at preventing a stock bubble. Margin lending has been a significant driver boosting Chinese shares, helping the Shanghai Composite clinch repeated seven-year highs earlier this year.

But the news scared individual retail investors—who make up the bulk of markets—and resulted in Shanghai and Shenzhen stock indices losing 12 and 15 percent respectively, in the past month.

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"This is the challenge China has, every time you try to adjust the economy, you have leverage building up. When you have this kind of build-up, you need to have price support because you don't know how far it will extend and what kind of knock-on impact it could have. A very rapid unwinding of leverage means massive dislocation," Will Oswald, global head of fixed income, currencies and commodities research at Standard Chartered, told CNBC.

"When you've got that type of leverage built up through margin accounts, it's a lot harder to stem the correction, but China is working on balancing between the moral hazard risks of supporting the market versus dislocated prices," he added.

Side-effects of intervention

"The longer the support program is kept up, the more distorted the market becomes. For now, more long- term Chinese investors are coming in [based on expectations for prolonged relief] but international investors will remain nervous," IG's Aw warned.

Indeed, foreign investors do seem to be staying clear. China equity exchange traded funds, suffered outflows on 14 of 17 trading days in July, totaling $1.1 billion, or 5.9 percent of assets, research firm TrimTrabs said in a statement on Tuesday.

Despite the government support, "many high-profile foreign investors have become more pessimistic on China, citing asset value depreciation, psychological damage, capital outflows, and poor July industrial profits growth and manufacturing data," Bank Julius Baer said in a note on Wednesday.

But as for the impact on Beijing's credibility, not everyone is pessimistic.

"Chinese intervention in markets has been much criticized, but is actually little different from that done by G4 countries during previous panics," Mark Tinker, Head of AXA Framlington Asia, said in a report on Monday.

"Aside from the obvious irony that Quantitative Easing (QE) across the West has been distorting markets for the last six years, the criticisms look a little harsh, especially if one recognizes that in contrast to the accepted wisdom, China was trying to prevent a bubble, not stoke one up."