Tumbling stock market

Despite government announcements to put a halt to initial public offerings (IPOs) and efforts to pour funds into the market, the CSI300 index of the largest listed companies in Shanghai and Shenzhen ended down 1.8 percent on Tuesday, July 7, while the benchmark Shanghai Composite Index (SCI) lost 1.3 percent.

It is the latest in a series of stock plunges that have hit the world's second-largest economy since June 12, raising concerns for China's leaders who are already struggling to avert a sharper economic slowdown. The SCI has dropped by nearly 30 percent in three weeks - albeit still up 80 percent year-on-year - including a 12-percent loss last week.

Support measures

Chinese authorities have directly intervened to stop the stock market slide. After a host of measures such as a cut in interest rates, relaxation of margin trading rules, and an announcement that government agencies would lend money to brokerages failed to the reverse the slump, the China Securities Regulatory Commission (CSRC) cut back on the number of initial public offerings (IPOs), then went a step further by halting them for the near future.

In view of this, 28 Chinese companies said over the weekend they would postpone their initial public offerings (IPOs), according to state-run news agency Xinhua.

Separately, China's 21 major securities brokers announced they would spend no less than 120 billion yuan ($19.62 billion), or 15 percent of their total net assets, on exchange traded funds (ETF) that track the performance of blue-chip stocks, to arrest the market slump. They also pledged not to sell current equity holdings until the Shanghai Composite hits 4,500 mark (compared with 3,727 on July 7).

Moreover, the country's central bank is to start providing liquidity support for China Securities Financing Corp., a government-backed firm that funds brokerages offering margin financing. Xinhua also referred to local media stating that more than 200 Chinese-listed firms would halt trading of their shares, in an attempt protect themselves from the falling stock markets.

Credibility 'at risk'

Mark Williams, Chief Asia Economist at the UK-based consultancy Capital Economics, says that all this government-led support measures have supported a view that policymakers are in a state of panic because it feels that its own credibility is at risk.

The analyst argues that while in most developed economies it is usually clear which part of government has responsibility for a given policy goal, major decisions in China are made at the highest level of the Communist Party and all parts of the system are expected to fall into line.

"The result is that new initiatives come from all directions, including large and state-owned firms. Either way though, it is clear that the leadership has made countering the market fall a central goal," said Williams.

Having trumpeted the stock markets' rise until recently, the leadership now feels that their fall casts doubt on its competence, said the economist, adding he believes Beijing is now following a risky path.

"Our view remains that a market rally cannot run ahead of economic fundamentals indefinitely […] there is a good chance that the market rescue efforts are seen to be a failure in a few months' time," he warned.

But what has caused the slump in the first place? Things looked very different in the previous months. The Chinese stock market was among the world's best performers, with the key SCI surging more than 150 percent in 12 months, partly fueled by margin trading.

Market correction

But given the significant slowdown of the Chinese economy during 2014-15, what the rapid rise in Chinese stock prices actually reflected was, to a significant extent, speculative pressures, as Rajiv Biswas, Asia-Pacific Chief Economist at the analytics firm IHS, told DW.

The decline in Chinese residential property prices at the time, which had been a preferred form of investment for Chinese investors in recent years, also contributed to the surge in the stock market.

"Due to the speculative nature of Chinese investment in the mainland stock market since 2014, together with a significant use of leverage for these investments, the Chinese equity market became vulnerable to a sharp correction in recent months. Once the market began to plunge, the use of leverage became a double-edged sword that created significant further selling pressures, said Biswas.

In the face of such a bear market, he explained, efforts by China's Central Bank to cut the policy interest rate and reserve requirement ratio proved futile.

Other Chinese government initiatives to create a $19 billion fund to support equities would at best mitigate the slump, providing a buying window for desperate private retail and corporate sellers closing out of leveraged loss-making positions and margin calls to provide collateral to cover their losses, said the IHS economist.

Economic impact

So how would the event of an equity market crash impact the overall economy? No one really knows what will happen now or how long the slump will last. China economists such as Wei Yao of Paris-based Societe Generale bank argue that while a market crash would be an undoubtedly painful scenario - which would potentially shave 0.5-1 percent off real GDP growth in the following 12 months - the immediate damage should be manageable.

The reason for this, she explains, is that while Chinese households' exposure to the equity market has increased, it remains relatively small.

According to the China Household Finance Survey (CHRS) conducted by the South-western University of Finance and Economics, equity market investment represented 6 percent of Chinese households' financial assets in 2013, whereas cash accounted for 17 percent and bank deposits accounted for nearly 55 percent.

In comparison, the equivalent figures for households in Japan, Europe and the US in 2014 were 10 percent, 17 percent and 34 percent respectively, she said.

The analyst argues that given the limited exposure, the slump will only have a limited effect on wealth. The key aspect, however, remains consumer confidence. "This is hard to predict, but if the labor market remains stable, we think that households will not cut consumption significantly just because of misfortune in stock market investment," said Wei.

She warned, however, that the long-term harm to structural reform and debt restructuring could be much graver, if equity financing were to slow down. "If, in response to the market volatility, the government had chosen to set back financial market liberalization, the trust of investors would be hard to rebuild and equity financing, one of the critical elements of China's debt restructuring plan, would stall."

The bigger picture

But economist Biswas believes that the financial losses relating to leveraged positions simply add to the significant imbalances facing the Chinese economy, including the slump in the residential property market, weakening growth in investment spending, excess capacity in key industrial sectors such as steel, and the rapid rise in lending by shadow banks between 2010-2014, largely unregulated until very recently.

"Amidst so many economic and financial imbalances, the stock market slump adds to the headwinds facing the Chinese economy, raising concerns about a further slowdown in Chinese economic growth in 2016 and increasing the risks of a protracted period of moderate growth in China with global transmission effects."

The analyst also warned that there is a 25 percent risk of a China hard-landing occurring sometime over the next two or three years that would significantly impact the global economy.