OREANDA-NEWS. July 22, 2015.  To understand why the Chinese stock market has been so volatile, what effects that could have on the Chinese economy, and where that leaves investors, we spoke with Vanguard Senior Economists Roger Aliaga-D?az, Ph.D., in the United States and Qian Wang, Ph.D., in Vanguard's Hong Kong office. Additional perspective on Vanguard's investments in China from Joseph Brennan, CFA, head of Vanguard Equity Index Group, appears at the end of this article.

In a little less than a month, the Shanghai A-share market lost almost one-third of its value. What was behind the drop?

Ms. Wang: Headlines in the financial press have focused on the fluctuations we've seen recently, but if you're looking for an explanation of why the severe drop happened, you need to look a little further back in time and consider the strong rally that preceded it.

Only a year ago, the market was pricing in significant financial risks and concerns about a hard landing for the Chinese economy. Since then, however, policymakers have implemented a raft of measures, including ratcheting up infrastructure projects, loosening housing policies, lowering interest rates, and reducing required reserve ratios for banks. Those moves were successful in dissipating fears of a systemic financial crisis and a hard landing, but they also had the effect of kick-starting a market rally that gained momentum as retail investors piled in using their own money and buying on margin (that is, with borrowed money). So from the end of June last year to the market peak on June 12 of this year, the Shanghai SE A-share Index was up more than 150%. That backstory makes the recent correction of roughly 30% seem less surprising.

Mr. D?az: While China's equity market is now the world's second-largest by listed market capitalization, it's still an emerging market, and as such, investors should expect to see more pronounced ups and downs than they might in developed markets. In fact, even when taking into account the recent roller-coaster ride, volatility in the Shanghai Stock Exchange Composite Index over the past 15 years has not been much different from what we have seen in many other emerging markets.

Comparing volatility in developed and emerging equity markets

Comparing volatility in developed and emerging equity markets

Notes: Developed markets equities are represented by the MSCI World Index; Brazil is represented by the MSCI Brazil Index; India is represented by the MSCI India Index; Russia is represented by the MSCI Russia Index; and China is represented by the Shanghai Stock Exchange Composite Index. All returns are in local currency.
Source: Bloomberg.

Where do you think the Chinese market will go from here?

Mr. D?az: Investor confidence has certainly taken a hit, especially with the suspension of trading on some stocks and restrictions on selling for large investors that have been put in place, so that will likely weigh on sentiment for some time.

A more pronounced correction could come if policy stimulus proves less effective than anticipated or if economic and earnings growth projections disappoint.

Ms. Wang: On the positive side, the stock market correction has brought valuations back down to more reasonable levels, especially for larger-cap stocks. At the end of June 2014, the 12-month forward price/earnings ratio for the Shanghai Stock Exchange Composite Index stood at 14.3. That was in line with the 14.6 ratio for the MSCI All Country World Index. This year, while the rally drove the P/E for the index up to 24.2 on June 15, the correction helped push it back down to 14.7 on July 7. So overall valuations are now pretty close to where they were a year ago, before the rally began. Small- and mid-cap stocks have corrected more, but their valuations still seem a little stretched.

What potential effects might the market correction have on the economy?

Ms. Wang: Well, the effect on consumption should be limited. Only about 10% of household wealth in China is invested in the stock market; on average, real estate accounts for roughly 40% and bank deposits another 40%. (That may explain why Chinese stock investors tend to be very risk-tolerant, as equities typically do not represent a large part of their wealth.)

And in China, the economy is predominantly dependent on the banking sector rather than the equity market for financing, so we wouldn't expect to see a credit crunch.

Of more concern is the impact on the health of banks, given their exposure to margin lending. However, the exposure of the banking sector to the leveraged financing scheme in the equity market is around 1.5 trillion yuan (compared with the sector's total assets of 180 trillion yuan). Hence, financial institutions aren't likely to be hurt much either.

A worry over the near-to-medium term is that the government may reconsider pushing through financial reforms and further market liberalization. Recent government intervention to shore up the stock market has highlighted that progress toward those goals is likely to be gradual and bumpy at times. But again, this is to be expected from an emerging market undergoing a significant rebalancing and an opening up of its financial system in order to make it globally integrated.

Where does all this leave foreign investors?

Ms. Wang: I'd repeat that volatility of A-shares will probably remain high over the short term. That said, China's economic importance—even with growth having shifted down a gear—will continue to expand. Chinese shares, therefore, represent a large and growing slice of the global equity market and an important avenue for diversification for global investors. That's especially true for A-shares, as they provide exposure to a much larger pool of Chinese companies, including nonstate-owned enterprises and certain market sectors that tend to be underrepresented in the H-share market. A-shares also happen to exhibit a much lower and time-varying correlation with the rest of the global equity market, adding to their value as a diversifier in a portfolio.

Is China safe to invest in?

Mr. Brennan: Any emerging market represents greater risk, so we encourage investors to keep their portfolios balanced among other asset classes and countries. That said, China is one of the world's key emerging economies and the second-largest stock market in the world by market cap. With the world's second-largest GDP, China accounts for 11% of global trade and 8% of global consumption. As a result, China can offer significant long-term benefits for investors.

Is Vanguard still going to invest in China? Are you planning to proceed with adding China A-shares to Vanguard Emerging Markets Stock Index Fund?

Mr. Brennan: Yes. Vanguard currently gains exposure to China in our funds through a variety of shares (B, H, P Chips, Red Chips) available offshore. We are not currently investing in A-shares but plan to begin doing so later in 2015 for the emerging markets fund. After we begin buying A-shares, we plan to transition them into the fund over the course of a year. This averages the cost of the shares, meaning more shares are purchased when prices are low, and fewer are bought when prices rise.

As an indexer, we invest our funds according to the indexes they are benchmarked against, with the goal of matching both the return and the risk of the markets that are represented in the indexes. We do not base our decisions on whether to include or exclude individual securities or countries on current market volatility. Rather, we make strategic asset allocation decisions that are based on the long-term availability and appropriate opportunity set of the investments.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Diversification does not ensure a profit or protect against a loss.
  • Foreign investing involves additional risks including currency fluctuations and political uncertainty.
  • Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.