Last week's bloodbath in China's A-share markets has stoked fresh fears that the world-beating equity rally is about to come crashing down.
The Shanghai and Shenzhen benchmarks plunged more than 6% at the close on Friday - with stocks off more than 10% from their recent highs. The Shanghai benchmark lost 13.3% over the week in its worst retreat since the global financial crisis.
The triggers for the sell-off were attributed to the usual suspects: rich valuations, new offerings draining liquidity from the market, a spike in the seven-day interbank repurchase rate, further restrictions on stock financing and, the old standby, slowing economic growth.
None of this is news - or central to last week's market panic and the subsequent freefall in stock prices.
Driving valuations in China is government policy. Not corporate earnings. In the topsy-turvy world of A-shares investment, the only real price catalyst is policy change.
For close on a year, investors have been betting that Beijing wants the stock rally to continue. A buoyant stock market is supportive of two policy goals high on the government's agenda:
- Successful internationalization of the renminbi
- Private-sector participation in China's economy
Key to Beijing's quest to remake the renminbi into a genuine global currency is the phasing out of capital controls. Convertibility is a major consideration in the IMF's deliberations on whether to designate the renminbi a reserve currency. Inclusion in the SDR basket is important to the Chinese leadership who sees it as a major breakthrough in the international use and acceptance of the renminbi.
Spearheading the trial in relaxing exchange controls are two cross-border stock trading links: one launched last November between Shanghai and Hong Kong and one to be rolled out later this year between Shenzhen and Hong Kong. (Hong Kong is considered offshore for currency and investment purposes.)
The schemes are more than just pilot programmes to facilitate trading between stock exchanges.
They are a landmark experiment in the free flow of billions of dollars every day between a hard-currency regime (Hong Kong) and a non-convertible one (mainland China). Investor participation is crucial for the experiment to work. And a bear market is unlikely to be conducive to enthusiastic participation.
Beijing is also targeting private-sector money and expertise to jumpstart the economy. One way would be through equity shareholding. A campaign to push state companies to broaden their ownership structure to include more private shareholders is already underway.
(The nation's fifth biggest lender, the state-run Bank of Communications, led the change in the banking sector in a filing last week to the Shanghai Stock Exchange on its broader ownerships plans. Its share price jumped 5% on the news.)
Then there is the not insignificant matter of Chinese stocks joining the MSCI emerging market index. Inclusion of all Chinese domestic shares in the widely-tracked index could trigger the largest-ever global equity rebalancing of portfolios - diverting huge sums of capital in exchange-traded funds and other passive investments into Chinese stocks.
Small wonder A-shares have been on a bender.
But China's smart money has been keeping a close eye on the exit - ready to dump at the first real signs of policy change. Since January when the regulator tightened rules for entrusted loans which have been providing funds for stock purchases, investors have grown increasingly skittish.
Confidence is a fragile commodity in a market where policy U-turns can happen overnight and with little warning. The merest whispers are enough to set off huge price swings. Even a change in the way trading volumes are calculated is said to have helped trigger last week's steep market sell-off.
Beijing may not want to kill the stock party. In fact, the securities regulator has issued a call for calm following last week's rout. But in keeping the bull run from turning into a mad cow rampage, the fear is that the authorities might inadvertently choke the beast.
That domestic investors are still keen on staying in the market is reflected in the almost US$1 trillion locked up in subscriptions for last week's flood of new offerings. IPOs remain hot.
But the days of easy pickings are gone. China's world-beating equity rally is about to turn into one huge roller-coaster ride. Money could still be made. But the faint of heart should get off before the next stomach-churning dive.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This report has been prepared on the basis of information that is believed to be correct and from sources believed to be reliable, with no express or implied warranty as to the accuracy or completeness of any such information.