Fragile China? Don’t be too sure

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With earnings season now in full swing, China remains the buzzword – but for all the wrong reasons. As analysts and investors who have questioned the strength of the world's second-largest economy start to look a lot less like Cassandras wailing in the wind – the question remains: When will the Asian powerhouse stabilize?

Short answer: it's tough to tell at this stage. You only have to look at the recent accelerated selloff in commodities markets to appreciate that. But as we hear more concerns and downgrades to the outlook tied to weakening growth in China in the coming weeks, and even more headlines regarding Chinese market volatility, it is important to remember that some people see this is as merely the growing pains of an economy that could very quickly turn around and surprise us.

Firms like Peugeot, Volkswagen, Phillps and in the US United Technologies continue to highlight the challenges of doing business in a slowing Chinese economy.

No one should be surprised. Most analysts and investors have been questioning the strength of reported growth for several quarters – nonetheless last week's 15-month low in factory activity felt pretty startling. We can also add in the latest China PMI this weekend falling to a 2 year low in July.

Worry on the way down?

Investors have lost confidence in the face of extreme volatility in Chinese equity markets. The Shanghai Composite posted its worst monthly loss in almost six years 14.3 percent in July.

It's worth bearing in mind that the index managed a 130 percent rally over the last 12 months – all in the face of Chinese growth being revised lower, corporate profitability being squeezed and a sharp hike in non-performing loans at the banks that dominate the index.

If we were able to deal with weakening growth on the way up, surely we shouldn't worry more on the way down -- particularly if that sell-off brings greater convergence between price and fundamentals?

To put it in perspective, the Chinese market must be assessed apart from the Chinese economy in the same way we did for the US economy when the stock market crashed in October 1987. That's easier said than done when faced with the unprecedented steps Beijing took to stem the tide of outflows. The Chinese government aren't the first to try and prop up domestic equity markets, look at Japan, the US and now Europe. But that's the only policy defence I can provide, as Beijng's efforts are clearly unsustainable even in the short term.

Nicholas Consonery from Eurasia expects a pretty swift retraction. 'We expect that over the next 2-3 weeks Beijing will begin to remove some of its restrictions which are unsustainable, including specifically the prohibition on selling shares that is in effect for any shareholder owning more than 5 percent of a given stock. The government can for a longer duration sustain its freeze on IPOs and mandate the CSF to remain an active purchaser of shares. But this gradual removal of interventions suggests that the risk of continued volatility in the near-term remains quite high'.

For President Xi Jinping, who has tied his credibility to a stock market rally, appearing so detached from fundamentals is one thing, but trying to maintain the perception that he's still very much focused and willing to bear the cost of liberalization is quite another. Xi, welcome to the free market,volatility-style warts and all.

The ultimate question now is whether Chinese authorities continue down this interventionist track, or give up, pull back and allow monetary policy to carry the burden. I'm talking about further bank reserve requirements and benchmark rate cuts. Either that or Chinese officials could end up backing themselves more firmly in to a corner with additional restrictive measures that ultimately risk a greater surge in volatility in the future.

The decision not to include Chinese shares in the MSCI index now looks exceedingly wise. Current attempts by Chinese regulators to support the market have surely delayed the date when Chinese companies will finally be included in this global index.

That brings to mind other risks faced by China -- such as the impact on its international profile. Last Friday Chinese regulators said they would strengthen the supervision of program trading after recent sharp swings in the stock market. They have already suspended several trading accounts for irrelegular trading activity. Can we assume that domestic trading accounts were scrutinized to the same degree as foreign? And for those larger shareholders who were held in lossmaking positions unable to close out positions?

What damage will the combination of weakening growth, intervention and greater scrutiny do for inbound investment? None of these issues are new but it is another unwelcome reminder.

Michael Pettis, from the University of Peking asks the question very eloquently in his latest blog. 'Either way the panic and the policy responses have opened up a ferocious debate on China's economic reforms and Beijing's ability to bear the costs of the economic adjustment."

China is quietly liberalizing

There's a definite sense at this stage that companies operating in China are starting to understand that the slowdown is part of a structural adjustment to a less growth-intensive model rather than just a cyclical downturn.

But why does that have to be a bad thing? Whenever it feels like a strong consensus is building in financial markets, it can often be time for a rethink.

Over to Steen Jacobsen chief Economist at Saxobank who told CNBC's Squawkbox this week that 'financial deregulation is happening faster than anyone ever thought."

So while we're focusing on China's interference to support the stock market, behind the scenes China is quietly liberalizing.

While many analysts ask if the Chinese government may decide to devalue the currency to support growth going forward, Steen Jacobsen, chief economist at Saxobank, argues we havent seen anything yet: "The RMB will overtake the GBP as the number three currency (in FX volume) in less than three years. China will dictate the cost of money, but China will also be engineering a global restart of growth exactly as they did in 2008, but this time the plan is more grand and ambitious."

He argues that China's Silk road investment plan will spread to the rest of the world over the next two years as China makes a move to create one big trading zone across Asia. And "what China does with its 3-4 trillion USD reserves is far more important ultimately than if and when the Federal Reserve hikes rates."

Right now for investors in China up to three years may feel like a lifetime, particularly when faced with market volatility, questionable data and uncertainty over the policy response. But it's worth also bearing in mind for exactly these reasons too that China does have the potential to adjust more quickly that we imagined and catch the sceptics out.

Julia Chatterley is a CNBC and European reporter covering key business and political events. Follow her on:@JChatterleyCNBC