Everything You Need to Know About China's Stock Markets

Even as China’s stock markets rebound after a brutal selloff, they are behaving like no other markets in the world.

Taken together, China’s two stock markets rank second in the world in market capitalization behind the New York Stock Exchange, and in the top 10 in terms of number of listed companies.

Despite their size, China’s markets trade like the wildest emerging markets with huge volatility, big boom and bust cycles driven by fast-trading individual investors and heavy involvement from the government. Unlike every other major stock market in the world, China’s markets are almost completely closed to foreign investors.

China’s modern stock markets are young by global standards, with trading resuming 25 years ago after being interrupted for decades by the Communist revolution. They were born out of the reforms of Deng Xiaoping, who transformed China from a poor, centrally planned, rural economy into the vibrant, export-oriented juggernaut that remains one of the world’s fastest-growing major economies, despite a big slowdown in recent years.

Shanghai has traditionally played host to the biggest state-owned banks and energy firms, while the more rambunctious Shenzhen market is composed of companies from the freewheeling private sector. The ChiNext market, often called China’s Nasdaq, is based in Shenzhen.

Hong Kong is another story. The former British colony, which has a separate legal system from mainland China and a longer history of market development, has traditionally been more accommodating to institutional investors, which account for around two-thirds of trading.

Beginning in the mid-1990s, China started to list its biggest state-owned enterprises in Hong Kong. Known as H-shares, these companies include banks, oil companies and infrastructure builders and now account for half of the shares traded in Hong Kong.

China has allowed a limited number of foreign investors to trade in Shanghai and Shenzhen for the past few years, granting quotas to major investors. Last year that changed when Chinese Premier Li Keqiang announced the Shanghai-Hong Kong Stock Connect, which opened the Shanghai market to global investors. Shenzhen is scheduled to join the Connect later this year.

Even with the boom in the Chinese stock market over the past year, foreign investors were wary of diving in. The flow of cash into Shanghai remains far below the daily limits.

The two things that make China’s markets unique were on clear display as shares tumbled by a third over the past month. The government plays a heavy role in the market, doing things that could never happen in most other countries, but small investors ultimately control the trading.

Trading volume on the Chinese market is four times bigger than on the NYSE, with 3% of the market by value turning over every day. On the NYSE, that number is 0.3%.

For Matthew Vaight, global emerging markets portfolio manager at M&G Investments, which manages $400 billion as of March, recent trips to China have underscored the sense of the public’s fascination with the stock market.

“Everyone, from translators, to taxi drivers to investor relations, was checking their phones every few minutes to look at share prices,” he said.

But that didn’t instill confidence in China’s markets. It reflected, rather, “a market dominated by retail participants who are essentially gamblers,” he added.

This year’s rally was heady, even for China, largely because the government, hoping to get the market going, opened the lending spigots to individual investors. These traders borrowed a total of $365.1 billion, a fivefold increase in a year, and plowed their cash into stocks.

For years, the Chinese government has attempted to entice big money managers to counterbalance the influence of millions of mom-and-pop investors. These efforts were often interrupted by market crashes.

That’s what happened starting last month. As markets fell, the government did everything from ordering companies and fund managers to buy stocks, to boosting funding so small investors could borrow more to buy stocks.

Episodes like this are proof that China isn’t yet willing to allow a real market, said Michael Every, head of financial market research for Asia-Pacific at Rabobank.

While governments and their central banks in developed markets such as the U.S. and Japan have intervened in the past to prop up markets, “all those markets are still better regulated and more transparent,” he added. “You don’t get naked interference on this level.”

Perhaps the most surprising lesson that investors learned from the selloff was that companies would suspend their own shares. In a now-you-can-trade-it, now-you-can’t development, half of the companies listed on Chinese markets suddenly stopped trading this week.

“From the perspective of a global investor, this arouses mistrust,” said Toshiyuki Murai, chief investment officer for Asia ex-Japan at Sumitomo Mitsui Asset Management (HK) Ltd.

The selloff, share suspensions and government actions all will likely be a setback for China’s efforts to open its markets. The market peaked just before index provider MSCI Inc. decided not to include Chinese domestic equities in its flagship Emerging Markets Index, which is tracked by funds managing some $1.5 trillion.

Investors say the chances that MSCI will soon add Chinese markets to its indexes have likely dimmed over the past week.

There’s a bright spot amid all of the wackiness of Chinese markets. Unlike the U.S., where a wide swatch of the population is exposed to the market and a big selloff can make people wary of spending, the Chinese stock market doesn’t have much connection with the real economy.

Shares tend to rise and fall on sentiment and government actions, rather than economic fundamentals, and despite all of the drama they create by trading shares, a relatively small proportion of China’s vast population actually invests in the market. That means the economy can remain relatively protected from the stock market’s ups and down.

“The country’s stock market plays a smaller role in its economy than the U.S. stock market does in ours, and has fewer linkages to the rest of the economy,” Bill Adams, senior international economist at PNC Financial Services Group, wrote this week. “This probably limits the potential for China’s equity correction to trigger widespread economic distress.”

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