Here’s Why China's Stock Market Sunk

China's stock market is free-falling again. Much like they did during the summer of 2015, Chinese stocks are dropping precipitously, reigniting worries about the health of the world's second-largest economy.

On two separate occasions this week, the market fell by 7%, prompting newly instituted circuit breakers to halt trading for the day.

On Thursday, authorities suspended those circuit breakers after conceding that they may be doing more harm than good by driving investors into a panic. The flip-flop only added to the sentiment that the Chinese government doesn't know what it is doing.

China Devalues Its Currency

Compounding the recent China jitters has been the surprisingly swift decline in the country's currency. The yuan sagged to a five-year low against the U.S. dollar last week, and analysts say more losses could be in store.

Of course, if the market were left to its own devices, the yuan would almost certainly be down even more. The People's Bank of China maintained the currency at an artificially high level for much of last year, burning through hundreds of billions of dollars of foreign exchange reserves to do so.

Only in August of last year did the PBoC finally move to weaken the yuan, but only gradually. As investors rush for the exits, the central bank continues to use its multitrillion-dollar foreign exchange stockpile to manage the decline in the currency.

According to government figures, China's foreign exchange reserves dropped $513 billion to $3.33 trillion last year, with $108 billion of that coming just in December.

Experts Respond

With that context in mind, ETF.com sat down with two experts to get their take on the latest events in China. We asked them about three key areas as they relate to China: the stock market, the currency and the economy.

ETF: What are your thoughts on the fall in China's stock market; is it destined to fall further, and is the government's constant intervention helping or hurting?

Brian Jacobsen, chief portfolio strategist, Wells Fargo Funds Management: China has a communication problem more than an economic problem. Every depreciation of its currency is viewed as an act of desperation to prop up exports.

But in fact, it’s the natural consequence of letting the [yuan] float. Back in April, I thought it was 10% overvalued. We’re past the halfway point in terms of getting closer to fair value, so maybe the worst is behind us.

The intervention in the stock market is a form of interference. Now they have to intervene to get rid of the interference. The alternative is to abruptly let things settle where they should, but the risk is that things will get materially worse before they get better.

That’s why the recent moves to eliminate the trading circuit breakers and modify the restrictions on major shareholders from selling are half-baked, but better than doing nothing.

(Check out our Definitive China ETF Guide 2015)

Matt Collins, head of US ETF Capital Markets, CSOP Asset Management: The government in China is trying to drastically change its market by opening it up to the world in a time frame that is almost unheard of given its size.

Most investors view China from the perspective of where it should be rather than where it is in terms of a true open market. From this perspective, the intervention has damaged the view of many U.S. investors. But if you look at the more important long-term picture, this is a government that is willing to adapt and act more quickly than any governing body in the world and has quickly righted some of the unintended consequences.

We strongly believe this will make for a much healthier market in the future as we get beyond the short-term growing pains.

ETF.com: The country's currency, the yuan, is tumbling to levels we haven't seen in years. Are more losses in store, and why should investors care about the currency at all?
Jacobsen: As I wrote about recently on our blog, the problem for the market is apparently in the perception of why China is letting its currency depreciate. Instead of viewing it as natural, the markets are viewing it as a last-ditch policy decision to prop up exports.

Yes, the manufacturing sector is slowing in China, but the depreciation of the currency—and China’s allowing the exchange rate to be set more by market forces than by government fiat—is simply an attempt to remove a market distortion that has persisted for a long time. That’s why I don’t view these developments as long-term negatives for the markets. But I’m apparently in the minority.

Again, the only real reason people care about the currency is because of what it represents. People interpret every move down in the value as a way to prop up an unsustainable economic model. In fact, every depreciation is a baby-step toward something more sustainable. The currency has about 5% further to fall, but that’s only because other emerging market currencies were falling while the Chinese government was propping up the currency.

All those trillions of dollars in foreign exchange reserves were accumulated to prevent the currency from rising too quickly. Now they have to release the pressure valve. The key will be to do it slowly.

Collins: We’ve been pretty vocal over the last few months that [the yuan] will depreciate and that was the key reason we launched the CSOP MSCI China A International Hedged ETF (CNHX), the only physically hedged China ETF on the market.

Like its equity market, China intends to make the yuan a freely traded currency over time. In the short term, we expect the currency to depreciate to stimulate exports, but it's also a natural outcome of capital outflows.

ETF.com: Is China's economy still on track for 7% growth as the government is hoping for? Or are risks of a hard landing growing?
Jacobsen: It's inaccurate to debate whether China will have a hard or soft landing. The economy is still growing, so how can that be a landing? Growth will likely slow to 6.5% in 2016. It’s a step down to a more sustainable pace.

Collins: The idea behind a “hard landing” is fundamentally flawed. This is viewing China from a traditional framework that would be applied to countries such as the U.S. and other European countries.

In China, the market is dominated by “sentiment,” and outside investors tend to underappreciate this point and miss out on both the risk and reward of China investing. China is ripe with return potential that doesn’t exist anywhere in the world, and for those who take the time to understand local behavior, they can successfully weave China A-shares into their portfolios.

So, while growth will certainly slow, this will tend to impact small- and midcap companies more than others. They’ll need to transform their business model to be in line with the new economy, and will likely leave a more streamlined and developed economy in their path over the medium to long term.

Contact Sumit Roy at [email protected].