Up until a couple of months ago the Chinese stock market was one of the most profitable in the world, rising up to 140% in just a year-and-a-half. However, the Shanghai stock exchange has lost 35% of its value in the last month and Chinese authorities have intensified their efforts in the last three weeks to avoid more losses.
The instability in the Chinese stock market is in large part due to the nature of the investors participating in it. For instance, in Shanghai around 80% of investors are individuals or families with very little financial knowledge. These types of investors decided to enter the stock market because of their new-found capacity to invest some of their residual income.
The lack of financial acumen of said investors led to naïve trends, in which certain stocks were seen as sound investments merely because they were “going up”, and were bought with no further analysis. Consequently, the out of control damage in China’s stock markets is partly due to the erratic behavior of these investors.
Panic is Contagious
A distinction that is very important to highlight here, is that when the Shanghai exchange was falling heavily, and even though there was a “contagion effect” to the Hong Kong stock exchange, the losses were never as steep and as abrupt on the island as they were on the mainland.
This discrepancy reflects the investor base of the two exchanges. In general, investments in Shanghai are coming from a local source. At the Hong Kong stock exchange the more sophisticated foreign investors have a stronger presence. International investors also participate in the Chinese market with the ADRs (American depositary receipts) that are traded outside of China. ADRs are bought and sold on American markets like any other regular stock, and are issued by an American bank or brokerage firm.
When we analyze China as a market for non-native investors, we need to look at Hong Kong exchange since international investors mostly buy and sell their shares on the island instead of placing positions in Shanghai. When Hong Kong did fall, it was primarily due to psychological factors. Increasing risk aversion caused a change in the investors’ behavior. This shift implied, in many cases, that investment activity was focused on holding shorter positions instead of sticking for long – which in turn had the undesired outcome of increased volatility and risk.
Beijing’s Damage Control
As a result not only can we talk about a bubble (a dirty word after the global financial crisis) in the Chinese stock markets due to inflated prices, but we can also talk about China as an emerging market that is not quite ready to be considered a mature environment for investments.
The government has been trying to take the necessary steps to avoid further losses. Some of these restrictions – almost half of the stocks were banned from trading – show that China has some way to go before it can be considered a mature financial market akin to western standards.
Still, some of the policies that the Chinese government has followed show that they are committed to become a secure trading environment. Moreover, the monetary steps that the Asian giant has taken to fuel the economy show a strong commitment to improving financial competency. After seeing some of these policies begin to have an effect, it is time for investors to deeply analyze the structure of various public companies’ as part of their investment due diligence.
A deeper understanding of both specific sectors as well as studying the market in general will lead to safer investor behavior and hopefully, an improved Chinese stock market. Given the fact that China is a massive emerging market home to the second largest economy in the world and a government that is showing signs of commitment to make the economy grow, it would be no surprise to see China blooming again once Beijing gets its financial house in order.