Ever since China started to grow very rapidly, there have been those who have seen it as heading for a fall. Today is no exception. By contrast, I believe that it will continue to grow strongly for many years to come — albeit not quite so fast as before —and with a few bumps on the way.

The latest source of worry has been the performance of the stock market. Since June 12, the Shanghai Composite Index has fallen by 20pc. At one point it had fallen by a third. On occasions the index has fallen by as much as 7pc in one day. There has been widespread anxiety, in China and outside, that these sharp falls might cause not only financial chaos but also a severe hit to the real economy.

These fears are grossly overdone. Even after recent falls, the stock market is still up by about 100pc over the past year. Indeed, it is up by a quarter from the beginning of this calendar year. So the notion that massive losses on stocks are going to cause a plunge in the Chinese economy looks far-fetched.

As it happens, the stock market is not that significant in relation to China’s economy. The ratio of tradeable equities to GDP is running at just under 30pc. In most economies, including other emerging markets, the equivalent figure is over 100pc. Moreover, only one in 30 Chinese people owns shares directly, compared with about one in seven in the United States. And for all the popular enthusiasm for shares, China’s share owners are, on the whole, rich. They are unlikely to want, or be forced, to scale back their spending by incurring stock market losses. Nor is the equity market important as a channel for companies to raise finance.

One major concern is the degree of leverage in the market and the possibility of brokerages getting into trouble. More important than this, there is the embarrassment factor.

Via the state media, the Chinese government has encouraged people to invest in equities – right up to the moment the market crashed. This made policy-makers look inept and is one of the key reasons why they have stepped in to support the market.

David Fuller's view

Here is a PDF of Roger Bootle's article.

This article was written yesterday, so before today’s biggest drop by China’s Shanghai A-Shares Index since 2007.  Might this have changed Roger Bootle’s mind?

Certainly not.  Today’s slump is an example of capitulation selling.  The A-Share drop since mid-June is somewhat reminiscent of Wall Street’s Crash of 1987, although far less dramatic.  Back then, US institutional investors were less worried about the US stock market’s overvaluation because ‘portfolio insurance’ had been introduced somewhat earlier with launch of the S&P 500 futures contract. 

In 1987, investors knew that they could hedge their portfolios very quickly by shorting futures contracts, at least in theory.  However, at a time of increasing nervousness due to not only high stock market valuations but also rising Treasury yields, US stocks began to weaken in mid-October.  Moreover, on Friday the 16th US Treasury Secretary James Baker aired his concerns over weakening stock prices.  Following a nervous weekend, many US institutional investors attempted to hedge their long portfolios by entering futures contract sell orders before the opening on Monday 19^th October. 

In other words, everyone was trying to sell at the same time.  The stock market opening was considerably delayed, and when all the orders could be accommodated, trading opened at crash levels.  Forecasts of divine retribution and an economic depression soon followed.  The DJIA fell 508 points to 1738.74, a decline of 22.6%.  It went a little bit lower, as I recall, then ranged for several months with a slight upward bias before recovering and resuming its secular bull market, as you can see on this historic chart of the DJIA.

I mention this because I agree with Roger Bootle’s conclusion in the article above.  The Crash of 1987 was terrifying for investors but had very little impact on the US economy.  It was a market event.  Similarly, I think neither the Shanghai A-shares leveraged rally nor its sharp retracement since mid-June will have much of an economic affect on China, although this is probably a minority view today.  However, this drama is certainly frightening for investors involved and embarrassing for China’s government, which is likely to pump in more liquidity.

Interestingly, China A-Shares, now testing their rising MA once again, are now only slightly more expensive (p/e 18.91 & yield 1.74%) than the US S&P 500 (p/e 18.13 & yield 2.04%), according to Bloomberg.  However, the real value is in Hong Kong’s HSI (p/e 10.59 & yield 3.36%) and HSCEI (p/e 8.34 & yield 3.60%).