Booming China Market
Growth has been driven in China by an army of individual investors using margin loans and the shadow banking systemReuters

With all eyes on Greece, people probably don't want to know about a Chinese equity market rout to the tune of $3tn (£1.9tn, €2.7tn), prompting the communist government to throw in "everything but the kitchen sink" in response to this bursting bubble.

Chinese equities have shed 30% of their value since around the middle of June as an army of 90 million individual investors, which dominate the Chinese stock market, have sold shares as prices have fallen.

To combat this the Chinese government has been shovelling cash into blue chip stocks and telling people not to panic.

Meanwhile, since Monday 6 July volatility has been taken to new levels: the Shanghai Composite lost 5.1% before finishing 1.3% down and the Shenzhen was down 5.59%, taking it nearly 14% off early Monday's high, while the Shanghai Comp is 8% off these highs.

Maybe the Chinese government still finds it difficult to accept the fact that financial markets cannot be driven by policies and stock returns cannot be dictated by an authority.

Some 760 companies have suspended trading in their shares, equivalent to a freeze of $1.4tn, or something like one fifth of China's stock market value.

Economic consensus states China needs a thorough transformation of its economy away from a growth model that's based on exports and investments and in many cases over-investment that creates bad debt, to one that's driven by the consumer economy.

But pumping up the economy is unsustainable and could have the opposite effect of offloading losses onto household sector.

The Chinese growth story has been driven by margin lending, a means by which investors borrow money to invest using shares or managed funds as security. In times of high growth this technique can boost returns, but it can also magnify your losses.

Another risky factor in this equation is the country's large shadow banking system of non-bank financial intermediaries, using all manner of securitised vehicles and asset-backed means of market making.

Meantime, the nations' media has again tried to lend its support to calm nerves with the Securities Journal suggesting that the Chinese economy has the basis of a long-term bull market.

People's Daily reported: "Confidence is more precious than gold. That's what Chinese investors need at this moment; confidence, not panic."

Analysts at Rabobank said: "Basically, China had hoped an equity bubble would rescue its property bubble while not worsening the debt picture: those hopes look forlorn, with serious consequences for all of us.

"Most worrying is that there isn't really much China can do at this point: if a retailer's share price means it needs double-digit retail sales growth for 20 years ahead to get the Price-to-Book value back to a reasonable range, what difference will 25bp, 50bp, 75bp, or even larger reductions in benchmark interest rates, or equivalent cuts in reserve ratios, make? (Though that is unlikely to stop China's journey towards ZIRP and QE, as the US, Japan, and Europe have shown.)"

Creating a sovereign fund to mitigate the non-fundamental shocks is generally a good idea for emerging markets, but to assign a political task to these funds that they need to support the market index to a certain level simply won't work.

Pumping investment into stocks of large state-owned enterprises which are large cap stocks means the index is supported to an extent, but most of the other stocks still fall harshly, many of them more than 10%.

Assistant professor of finance Lei Mao, of Warwick Business School, said: "I am surprised at the actions of the government; these actions are like casting political pressures to modify the trading behaviour of investors or to blatantly dictate how investors should trade, just to meet the political goals the government wants to achieve from the stock market.

"If the government aims to sustain a healthy market as a venue for financing, the rise of state-owned enterprise stocks are only aesthetically meaningful, since these enterprises never need any financing and they are not good investments anyway.

"When you create a sovereign fund and the purpose is to achieve political value from a rising market, then the allocation of funds will inevitably be distorted."

Professor Lei pointed out that the Chinese government has restricted public funds from selling certain stocks – particularly, the pension funds are not allowed to sell any stock. This kind of direct ban destroys portfolio reallocation in the current market conditions, and the market is again distorted.

"These distortions, in today's market, create a significant flow of funds to large state-owned companies – a 'flight to state'. Plus they might create the reasons for another free-fall in the near future.

"Even an optimistic investor should not participate in the market for now. The government should learn, if not from the long histories of other markets, from their own mistakes," he said.

Lesson from Japan

A look back at Japan's dramatic economic slowdown in the 1990s suggests several lessons for China. Forecasters were extremely slow to recognise how much Japan's growth potential had dropped and the collapse of asset prices had profound and long-lasting effects.

Global growth was not very badly affected in the following decade, with advanced economies performing quite well, but there were negative regional spillovers that contributed to the Asian crisis in 1997-98.

Trade exposures of the major advanced economies to China today are mostly quite moderate and similar to exposures to Japan in 1990, with the exception of Germany.

Analysts from Oxford Economics said: "Asian countries have intense trade links with China, greater than they had with Japan 25 years ago. The direct impact of a sharp Chinese slowdown would be centred in Asia, as was the case following Japan's crash in the 1990s."