“I cannot forecast to you the action of Russia. It is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key. That key is Russian national interest.” – Winston Churchil

Global investors in Chinese equities might agree with the above quote if Russia is replaced by China especially with its meddling in the functions of the stock market. Chinese stocks plunged dramatically a few weeks ago and now seems to have stabilized. However nobody knows how long this state-created stabilization will last. The Shanghai Composite Index stopped falling after a series of interventions by the government. Despite the substantial decline, the index is still one of the best performing indices in the world with a year-to-date gain of over 18%. However in general, investing in Chinese stocks is not for the faint-hearted. The government is a big investor in investor in many listed firms and creates rules and regulates as it seems fit at any time. Basically the state is the perma cheerleader for the masses to invest in stocks and when the market crashes it intervenes to prevent the decline.

As a communist country with a capitalist economic system, China presents a unique problem for global investors in addition to being an emerging country. Unlike Brazil or India for instance, China controls the operation of equity “markets” on a constant basis. The following chart shows the wild ride of China’s equity markets in the past 25 years:

Click to enlarge

Source:  China’s Stock Markets: Nearly 25 Years of Wild Swings, WSJ, July 31, 2015

From the above article:

In the two years after China opened its stock markets, shares soared 1200% and twice fell by half. Investors seeking IPO shares rioted, overturning cars and smashing windows, leading police to use tear gas and fire their guns in the air to quell the disturbance.

China will celebrate the 25th anniversary of the opening of its stock markets later this year, and not much has changed since their founding. They vacillate between big government-driven rallies and equally dramatic selloffs that leave once-euphoric investors disillusioned and angry.

“China’s stock markets have developed quickly and their accomplishments are great, but they are very irregular,” Zhu Rongji, China’s premier at the time, said in 2000. “If they are to receive the people’s trust, the investors’ trust, then they have a lot of work to do.”

Stocks are down by 29% from their peak in June, and investors have continued to sell shares despite the strongest efforts ever by Beijing to prop up prices. The current bear market—defined as a fall of 20% or more from a peak—is the 27th that investors have suffered in the past 25 years. It is the 21st worst in terms of losses.

Shares have lost half their value three times, and plummeted by two-thirds once, in 1993-1994, when the Shanghai Composite Index fell by 67% from its peak to its low point.

The 27 bull markets have been equally dramatic, though none has come close to the initial 1200% gain. The market has gained more than 100% on eight occasions. The most recent bull market, which began in December 2012 and stretched until June, making it the longest in China’s history, clocked in at 164%.

Here is another chart of Chinse regulators in response to the recent crash:

Source: Lessons in distorting your own market from China’s “national team”, FT Alphaville

The following chart from Bloomberg is another take on this topic:

Via The Big Picture

In conclusion, before venturing into the Chinese stock market, investors should be very cautious and be prepared to deal with unforeseen actions by the state. While boom and bust cycles are common in emerging markets, in China it is amplified because of the government’s involvement in markets.

Chinese equities have been on a roller coaster ride for the past few months. Since reaching the peak in June this year, the Shanghai Composite Index has fallen by 29%. However despite this plunge, Chinese stocks are still in the positive territory for this year.

In a Guardian article on the Chinese equity market crash and its impct on the real economy, author Heather Stewart quoted IMF’s Managing Director Christine Lagarde’s views on thi topic. From the article:

Christine Lagarde, the managing director of the International Monetary Fund, played it cool when asked about the Chinese market gyrations in a press conference on Wednesday. She pointed out that the market was still up an extraordinary 80% over the past year, and added she was not surprised the government in Beijing was intervening to prevent the “disorderly functioning” of markets.

“That is the duty of central authorities,” she said. “The fact that they want to maintain a level of liquidity that is commensurate with an orderly process is quite good.”

In other words, while some have condemned Beijing’s efforts to arrest the share slide as clunky and authoritarian, Lagarde saw it as little different to the scramble by western governments during the 2008 crisis to prevent their financial systems from seizing up.

She was relaxed, too, about the potential impact of the share price slide on China’s real economy – the shops, factories and farms that create jobs and generate growth. “We believe that the Chinese economy is resilient and strong enough to withstand that kind of significant variation in the markets,” she said.

Source: As Chinese shares fall, the real fear is that the economy itself is grinding to a halt, The Guardian

I agree with Ms.Lagarde. The Chinese “real” economy is unlikely to be impacted adversely by the ongoing chaos in its equity market. This ie because despite the media hype, equity market participation by domestic investors in China is still low relative to other countries especially developed countries like the U.S.

In an insight.ful article, Anh Lu  and Chris Kushlis T.Rowe Price note that the crash in Chinese equities is projected to have a limited impact on households since equities sccount for a small portion of Chinese household assets.

Click to enlarge

Source: Economic Risks From China Equity Decline Appear Manageable, T.Rowe Price

Chinese households hold most of their assets in property and bank deposits and not in equities. Hence the correction in stock market should have low impact on households. Despite the media hype, fall in equity prices is unlikely to lead to negative predictions such as the collapse of the economy, the regime losing control of the state, mass panic, riots, failures of financial institutions, the economy plunging into a depression, etc.