What’s Next for China’s Market After Crash?

The government’s aggressive measures to stop a panic sell-off have steadied stocks but left big questions over outlook.

Inside A Securities Brokerage And General Stock Market Illustrations As China Stocks Plunge

A man stands next to an electronic display showing the Hang Seng Index figure in Hong Kong, China, on Wednesday, July 8, 2015. Hong Kong’s benchmark stock gauge plunged the most since the global financial crisis as an equity rout in mainland China rippled across Asia. Photographer: Jerome Favre/Bloomberg

Jerome Favre/Bloomberg

Over the past year it seemed as if China’s stock markets could go nowhere but up — until suddenly they went into free fall. Now in the wake of frantic official efforts to stop the rout, investors are wondering how long the newfound stability will last, and what remains of Beijing’s commitment to market forces.

Panic selling erased an estimated $3.2 trillion in value from the Shanghai and Shenzhen stock exchanges in the past few weeks, prompting authorities to pull out all the stops to prevent a market collapse. Support measures included the creation by Chinese brokerages of a 120 billion yuan ($19.3 billion) market stabilization fund, the extension by state-owned entity China Securities Finance Corp. of 260 billion yuan of credit to brokerages for stock purchases, the imposition of a temporary ban on stock sales by major shareholders and an official investigation of more than ten institutions and individuals for “malicious short selling.” Propaganda officials even began enforcing a ban on media outlets’ reporting news of distraught investors hurling themselves off of skyscrapers after seeing massive losses in their portfolios.

Those actions stopped the sell-off, at least for now. The Shanghai Composite index rallied by 13.2 percent in the three sessions between July 9 and July 13 before easing by just over 1 percent on July 14. At 3,294, the index was down 24 percent from its June 12 close but still up nearly 90 percent from a year earlier.

Yet the heavy-handed intervention has led many China observers to question the government’s commitment to market-oriented economic reforms and financial liberalization. The market rally that began a year ago was fueled in large part by such measures, including moves to allow the liberal use of margin trading, or buying stocks with borrowed money, and the opening of a direct trading link between Shanghai and Hong Kong.

“Recent efforts to rescue the market can be seen as major steps backward for reform,” says Victor Shih, associate professor at the School of International Relations and Pacific Studies at UC San Diego. The six-month ban on stock sales by major shareholders is particularly worrying, he says. “If the government can do this to some of its most privileged citizens, foreign investors may be even more vulnerable to asset seizures,” Shih says. “The recent events show that the Chinese government prizes control and stability above all other objectives.”

Beijing’s relaxation of curbs on margin trading in recent years played a big role in the market’s rally — and sudden downturn. “There is no question that valuations were stretched, and licensed leverage levels had grown significantly,” notes Paul Schulte, chief executive of Schulte Research International, a Hong Kong–based independent research house. “But these levels of leverage by licensed brokers was within limits. However, there was a high level of curb lending that was not licensed and was not being counted and which was illegal.”

Haitong Securities Co., China’s second-largest broker, estimates that as much as 1 trillion yuan in margin funds have flowed into the market outside of regulated channels, on top of some 2.3 trillion yuan in regulated margin loans from brokerages. On July 12, regulators moved to clamp down on shadow margin lending by instructing brokerages to review trades and enforce rules requiring the use of real names and identification numbers for margin trades.

The dramatic rise in stock prices over the past year had spurred warnings of a bubble before the market began to tank in June. In early April, emerging-markets guru Mark Mobius, Singapore-based chairman of $40 billion Templeton Emerging Markets Group, said Chinese stocks had risen too fast after a world-beating rally sent the benchmark equity gauge to its highest level in seven years, and that a 20 percent retreat was “very possible.” He noted that Chinese investors had opened a record number of new stock accounts and increased margin debt to all-time highs.

Last week Mobius was more optimistic, contending in a July 9 blog post that the violent pullback in Chinese equities had nearly run its course and that he was on the lookout for value. “I think we are probably getting close to a capitulation point in China,” he wrote. “We should see at least a short-term bounce soon, and many investors who didn’t get out before may use that move to do so. Then, we would expect to likely see sideways action until the market can hopefully recover, provided valuations are good.”

Kenneth Courtis, chairman of the private investment company Starfort Holdings and former vice chairman of Goldman Sachs in Asia, echoes Mobius’s sentiments. The question many investors are asking is whether China is in the beginning phases of an epic crash, similar to what occurred in Japan after the bubble popped in 1989 and to the U.S. stock market crash of 1929, or whether the setback is comparable to the violent but short-lived correction of the U.S. market in 1987, which was followed by a 12-year-long bull market. “I would say for the moment it is more the latter than the former,” says Courtis. “That is a vicious correction within what would be later seen as a new bull market which started a year ago. The market would have to fall another 30 percent to 40 percent before we could really say this is a super-duper bear market with potentially devastating consequences.”

Others are not so sanguine. Andy Xie, an independent strategist in Shanghai, notes that the authorities had encouraged a market rally in part to help the economy digest a growing mountain of bad debts left over from an earlier stimulus program, back in 2008–’09. “The chances are that China’s financial crisis has begun,” Xie says. “The game of ramping up asset prices to cover up bad debts is coming to an end.”

Not all top policymakers in Beijing agree with the approach the government has taken so far. “This time the stock crisis will become a very bad thing for Chinese, also for the world,” says a senior Finance Ministry official who is advising Premier Li Keqiang on the crisis, and who spoke on condition of anonymity. “My team and I are angry with the method used to deal with the crisis. This way is wrong and a waste of resources. We are trying to change the way to allow for true market-driven mechanisms.”

The official says China’s experiment with margin trading and short selling won’t end, but that oversight will be tightened to bar such activity outside of regulated brokerage houses and impose stiff penalties on illegal activities. “Rest assured that the stock market crash will not end financial innovation in China,” the official says. “But we will study what went wrong and impose new mechanisms that will make the markets more sustainable.”

Follow Allen Cheng on Twitter at @acheng87.