What Caused The Latest Chinese Correction?

Jun. 7.07 | About: Morgan Stanley (CAF)

Shanghai closed today at 3890.8, up 3.03%. It is the first time that there are more advances than declines (894 vs. 378) since the announcement of the tripled duty tax on 29 May.


Over the last seven trading days, Shanghai Composite has corrected by 21% from its peak of 4335 on 29 May to its lowest of 3406 on 5 June, and still by 10% as of today.

click to enlarge

This size of the correction was totally unexpected by the government; over the last two days there were various government officials trying to comfort the over-reacted crowds with bullish comments in different media.

In addition, four new equity oriented mutual funds were approved and will be launched next week. The last time a large number of funds were concurrently approved was on 6 Feb, when the market collapsed by 10% from 30 Jan to 5 Feb.

Obviously the government is trying to fix the aftermath.

So what was the cause for this latest correction? It was not the tripled duty tax; as I mentioned in my last article, the practical impact of it is insignificant.

The real cause was the poorly managed and inconsistent message from the government. Just a few days before the 29 May announcement was made by the Ministry of Finance, the media had confirmed with another spokesperson in the MoF that there was no such plan.

It is exactly this inconsistency which caused the market panic, as investors had no clue which message they could trust in the future.

I think such an inconsistency was unintentional and I believe that the Chinese authorities will learn from this incident and be more careful in the future when government officials talk to media.

Another by-product of this correction is a tightening of the A-share/H-share price gap from the previous 30%+ premium exhibited by A-share. As can be seen from the chart below, the Hang Seng China Enterprises Index (which tracks H-share in Hong Kong) has in fact gone up while the A-share index was free falling in the period.


This is the first time inexperienced Chinese investors (17% of the total trading accounts in China were freshly opened in past four months) got their fingers burned.

I believe Chinese investors will also start looking at other less risky investment vehicles which they are familiar with, such as QDII (Qualified Domestic Institutional Investor) funds, which the government recently relaxed. (Up to 50% of a QDII approved fund can be invested in equities from 0% in the past). As Hong Kong is the only authorized market for QDII funds, most of these funds will likely allocate their equity portion to Hong Kong listed H-shares, red chips and Hong Kong blue chips, all familiar names to Chinese investors; this will be a catalyst to the H-share index, though the absolute amount is still small comparing to the HK market cap.

Besides, there are more mainland Chinese investors using a gray channel to invest directly in Hong Kong stocks without going through QDII. Though RMB is not a freely traded currency, Chinese citizen is allowed to buy up to US$50K per year for their spending when they travel to Hong Kong. For a family with three members that’s already US$150K which is not a small number at all by Chinese standards. Though it is officially not allowed, some of them mayl still open a HK stock trading account when they travel to HK and place orders over the internet or phone. In fact, a local Hong Kong broker said today that around 50% of its orders are coming from mainland customers. I would not under-estimate this effect, which will be even more significant than the QDII channel.

I’ve also adjusted my trading strategy and will allocate part of my portfolio to H-share index ETF (2828.HK) rather than purely on A-share related ETFs (NYSE:CAF) (A-50 Tracker). Now I am equally bullish on both A-share and H-share.

Disclosure: Author has long positions in H-share index call warrant and A-50 index call warrant