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By Jason Stipp | 07-09-2015 09:00 AM

What's Going on in China?

Seafarer's Andrew Foster explains what led to the recent stock market volatility and what it means for the country's economy.

Jason Stipp: I'm Jason Stipp for Morningstar. After a stunning rally over the last year, Chinese shares have been on a roller coaster in recent times.

Here to offer his take on the situation is Seafarer Overseas Growth and Income Fund manager Andrew Foster.

Andrew, thanks for dialing in today.

Andrew Foster: Hi, Jason. Thanks for speaking with me.

Stipp: We have seen Chinese shares rally over the last year, and then, of course, we've seen some sharp sell-offs in recent times and some volatility actually in both directions.

Let's start with the rally first. Over the last year, what has caused Chinese shares to move up so quickly?

Foster: There is a confluence of several factors, some of which go back a few years. What I would say started it is that Chinese households to begin with have very little exposure to equities. They've historically had way too much of their savings and investments in residential real estate, and equities have occupied a small part of their portfolios. So there was a natural inclination to allocate more to equities that was building within the Chinese society.

However, that was fueled in a very aggressive manner--frankly an almost crazy and worrisome manner--by a very pronounced availability of margin finance. In other words, households were allowed to borrow large sums of money against sometimes very questionable collateral in order to purchase shares, which is a very risky undertaking. Especially, if the stock markets fall, it tends to mean that investors, having borrowed the money, will liquidate their shares quickly to repay those borrowings. So it makes the market very fragile and precariously balanced.

This availability of finance was spurred by the Chinese government in a certain sense, because the government was keen to see this rebalancing take place and especially to boost share prices within the country, which until the summer of 2014, about a year ago, were very depressed.

This is the historical issue that I eluded to. The Chinese government is very keen to clean up and sell off its large ownership within some of its state-owned enterprises. The government has very large ownership stakes in a number of major and minor companies across the country. And the government needs new capital because it has some fiscal problems that it has to deal with, and it wants to clean up its companies and sell off its stakes to the general public, to investors. I think that's the general intent of the government, but they wanted to do it at prices they deemed to be attractive.

A year ago, those stock prices were so deflated that there was a policy push within the country to get people to own more shares, and this spurred financial institutions to lend more to individuals to speculate in stocks.

So, a huge wall of money hit the market quickly, and this pushed the market up very rapidly in the space of a year. It is really exacerbated by the fact that the underlying stock market within China doesn't enjoy a lot of liquidity to begin with. So you suddenly have a huge wall of money hitting a stock market without a lot of liquidity to absorb that wall of money, and it pushed the market up to precarious levels in the span of the year.

Stipp: We have seen in recent days several sharp sell-offs. Can you pinpoint what actually caused shares to begin to sell off?

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