What is going on with China’s stock market?

With China seeing a record stock market slump this week, Lei Mao, Assistant Professor of Finance tries to make sense of just what is going on with the Chinese stock market

On Monday July 27 the Chinese stock market suffered its worst fall in eight years. The Shanghai Composite Index ended 8.5 per cent down, while the Shenzhen Composite index dropped nearly 7.6 per cent.

The plummet lead to around two-thirds of companies listed on the Chinese mainland losing 10 per cent of their value, the daily limit, before trade was suspended. On Tuesday July 28 the Shanghai Composite then dropped a further 1.7 per cent.

While Dr Mao expected shares to drop, he says it was surprising they dropped as much as they did and thinks it will take some time to recover despite the country’s central bank suggesting it will inject 50 billion yuan into the money markets.

"The large slump from Monday came as a surprise, I never expected a plummet so large. Even today it is still not clear what factors drove the plummet yesterday,” said Dr Mao, “the only explanation so far still seems to be that the investors are gaming with the government: they are trying to time the withdrawal of the government’s buying programme and sell off the market when the government exits.”

Dr Mao believes the government’s rescue plan over the last few weeks have helped created a false sense of security, which combined with gaming behaviour has led to trouble once again for the market.

Dr Mao added: "It seems the market supporting measures of the government in previous weeks created a second-round bubbles, and attracted more opportunistic gaming behaviour to exploit these bubbles. The bubbles and the gaming behaviour made the market actually chaotic, even though it seemed to be peaceful in the last week.”

In light of the chaos in the market the China Securities Finance Corporation has vowed to conduct a further crackdown on short selling.

However Dr Mao believes the measures taken so far might have actually negatively affected the market

He said: "Another conclusion one can make is that the government’s supporting measures squeezed out the endogenous liquidity of the market. Due to a lot of price distortions, an investor who does not want to gamble with the government cannot find any strategy to participate.

"So the more liquidity the government injected in the market (which was blind liquidity), the more private liquidity (which could have been smart, long term money) was squeezed out. It is not surprising that, in a market without any long term investors who care about fundamental value, any rumours could trigger very large price reactions.

"However, though I did say weeks ago that there could be price distortions and investors should be cautious, I would hate to say that I had foreseen the yesterday’s plummet. As in a casino, anything can happen: one cannot tell where the China stock market would lead, and how the Chinese regulators would do, as they almost depleted their aggressive tools."

Although things seem to have taken an upward turn again on Wednesday 29 July's results, Dr Mao suggests it is still not a true recovery as the market is still well under the volume it was previously.

Dr Mao has previously discussed the volatility of the Chinese stock market and its possible impact on the global economy in an interview on On The Money Radio.

Lei Mao teaches Corporate Financial Management on the MSc Accounting & Finance and Corporate Finance on the Finance PHD programme.