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."