Emerging dangers

The Shanghai Composite is a widely used index of all companies listed on the Shanghai exchange, while the ChiNext index is an index of fast-growing businesses listed on a NASDAQ-style board in Shenzhen, with weaker listing standards than on the main exchanges.

Following a period of consolidation, July 2014 saw the start of a major bull move in both indices. The Shanghai Composite gained about 150 per cent to its peak in June this year, and the ChiNext index rose by 200 per cent. This was followed three weeks later by a fall of about 30 per cent for the Shanghai Composite, and more than 40 per cent for the ChiNext index – the latter suffering from many stocks not being able to trade at all.

The Bloomberg data shows that the rise in the Shanghai market was fairly uniform throughout 2014. The ChiNext market had a fairly quiet 2014, before rising by more than 150 per cent in 2015.

In 2014, three things occurred. First, house prices stopped rising and in fact began to fall as it became apparent that supply was running ahead of demand in many cities. Belief in ever-increasing house prices began to evaporate and the savings that would otherwise have funded property purchases moved to other assets.

Second, the People’s Bank of China changed monetary policy as they became confident that inflation was coming back under control and growth began to slip due to poor demand for Chinese exports in Europe and North America. They began to lower interest rates and reduce reserve requirements in the banking system – in western terms, they initiated a new cycle of monetary policy easing.

Third, the Shanghai-Hong Kong Connect investment bridge was launched, which allowed investors in each market to trade shares on the other market using their local brokers and clearing houses. This was announced in April 2014 and went live in November. Many more investors were then able to trade shares on the Shanghai exchange through their Hong Kong brokers.

The rise in the Shanghai market in 2014 was initially ignored by the ChiNext market, a much smaller and less liquid market where trading is dominated by local investors, but at the start of 2015, they too began to bid up share prices.

There are no legal casinos in China, so the sharp rise in share prices in these speculative stocks in Shenzhen sucked in many new investors and finance companies that were prepared to provide capital for speculative investment. Margin debt – debt linked to the purchase of shares – exploded in China in 2015, fuelling demand and pushing up prices at a crazy pace.

At some point in all such market cycles, the confidence in ever-rising prices begins to crack and markets go into reverse. This is what has happened in China – as share prices began to fall, so margin calls were made and forced sellers were created, effectively acting to intensify the downtrend.

Initially they sought to ban the selling of shares, and tried to prevent brokers from accepting sell orders

At this point the Chinese government panicked, believing that investors would blame them for their losses, and this has created the extraordinary spectacle of a Communist government intervening aggressively in the stock market in order to protect capitalist investors from making losses.

Initially they sought to ban the selling of shares, and tried to prevent brokers from accepting sell orders. This was not immediately successful as there were few, if any, buyers in the market and so barely any trading could take place in the smaller issues which went limit down for several days in a row with no shares traded.

The government then went further, ordering brokers and institutional investors to go in and buy the market – this they did, mainly through ETF purchases which continued to trade despite the fact that many of the underlying holdings of the ETFs were not trading. At the time of writing, this has stabilised the market and halted the sharp decline.

For UK investors, the roller-coaster ride of the ChiNext is something to observe rather than participate in – it is a market of small domestic stocks, with relatively poor listing standards, where the investors are happy to gamble. It is now also a market where the government is prepared to intervene to generate the ‘right’ level of prices. This is not a market for serious investors at the current time.

The Shanghai Composite may, however, offer opportunities – this is the market where institutional investors do operate, both local Chinese and international, and where well-established companies trade. The recent setback has corrected about half of the gains seen over the last year and some investors such as Dale Nicholls, manager of the Fidelity China Special Situations fund has said that he sees this correction as a buying opportunity within a long term bull market for Chinese stocks.

Emerging markets have always been, and no doubt will continue to be, prone to rapid moves, both up and down, and China is very much an emerging market, particularly with regard to the behaviour and inexperience of its local investors.

For the long-term focused international investor, not much has changed this year in the structural growth prospects for the Chinese companies and the economy. For those who are optimistic on this front and understand the risks inherent in emerging market investment, this may be a good time to add to holdings in Chinese shares.

Jeremy Beckwith is director of manager research of Morningstar UK

Key points

Following a period of consolidation, July 2014 saw the start of a major bull move in both the Shanghai Composite and ChiNext index.

The sharp rise in share prices in speculative stocks in Shenzhen sucked in many new investors.

The Chinese government panicked, believing that investors would blame them for their losses.