Source: Deloitte’s Monday Briefing 13/07/15

Chinese equities have shot up since last year. In the 12 months to mid-June, its Shanghai Composite Index rose by 150%.

Tempted by cheap credit and official policy support for margin lending – which enables retail investors to buy equities with money borrowed from brokers – punters piled into equities.

Equities also benefited from the desire of many Chinese investors to shift savings away from what is widely believed to be an overvalued housing market.

The rally in the Chinese equity market has taken place at a time of growing concern about growth prospects for the Chinese economy. Last year China expanded at the slowest rate in 25 years. The general expectation is that China’s trend rate of economic growth is slowing. Against such a background China’s equity market rally seemed to have detached from fundamentals.

When sentiment changes in financial markets asset prices often move quickly. So it has proved in China. The benchmark Shanghai Composite equity index has fallen by almost 40% since mid-June.

The authorities have come up with a host of measures to stem the slide. Banks’ reserve requirements have been reduced and restrictions on margin lending eased. Last month, the Chinese central bank announced a surprise rate cut to boost the value of risk assets.

But as the sell-off continued their tactics have become more unconventional and increasingly desperate. IPOs have been suspended and funds encouraged to buy equities. Roughly half the companies trading in the market have suspended their shares.

Some worry that China’s equity sell-off could feed back into the economy, by weakening the financial system and underlining consumer activity.

For now this looks like a fairly small risk. For a start the Chinese market is far smaller relative to the size of the Chinese economy than Western markets are to Western economies. Equities therefore play a smaller, less influential role in China. Moreover, though the market has plunged since June, it is only back to March levels. Anyone who invested in Chinese equities a year ago would have more than doubled their money.

Also, margin lending to finance equity purchases represents a small proportion of all lending and probably not enough to pose serious problems to the financial system.

As for consumers, they have less than a fifth of their assets in the Chinese equity market. Lower equity prices are far less likely to affect consumer confidence and spending in China than in, say, the US, where households are more exposed, through savings, to equities.

Some argue that the real problem is not the sell-off in Chinese equities, but the way in which the Government has intervened to try to stop the slide. Such interference certainly fuel doubts about the authorities’ commitment to a more market-based economy.

But for us the big story is that China is trying to make a historic shift to slower growth and less reliance on exports and investment. In doing so the authorities have to strike a delicate balance between curbing financial excess and keeping growth going. But economies are not like vast, complex machines which respond precisely and predictably to direction. The precipitous sell-off in Chinese equities is a reminder that in rebalancing the Chinese economy not everything will go according to plan.