What's Going on in China?

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?

<TRANSCRIPT>

Foster: I wish I could pinpoint an exact factor. I think the peak of the market appears to have been June 8, although the really pronounced selling started about July 3.

It's really difficult to pinpoint the reasons for the selling pressure with certainty. I think certain financial institutions in China began to be worried about the amount of margin finance they'd extended; they began to curtail the amount that might be available. And just the sheer imposition of some restriction on margin finance was enough to send the market a bit lower and start a snowball of fear beginning to mount within China.

Stipp: The Chinese government has been actively trying to prop up the stock market. Do you think that their efforts will be successful or are they essentially just prolonging the inevitable that's going to happen in that market?

Foster: I think it only delays the inevitable, personally. In fact, there are certain policies they can undertake that might make it far worse, and that seems to be the case so far.

The Chinese government is allowing companies to voluntarily suspend the transaction of their shares on the stock exchange. Right now a huge number of stocks within the domestic market within China are frozen and are unavailable for trading. I think that's putting even worse pressure on those households and individual investors who are trying to exit the market. They are being forced to sell those few shares that are still trading, and that is putting more pronounced pressure on those limited shares and pushing them lower faster, which in turn is creating more fear and more reason to sell. So I think some policies may actually create a more pronounced sell-off.  

The one exception I have to this is: Our own government in the United States had some success with its big bazooka in 2008. I suppose there are certain policies that the government in China could undertake to really hit the Chinese stock market with overwhelming force to support it. It has been tried in this country somewhat successfully and the Chinese may seek to emulate it. But for the most part, I would have to say that the probability is that they are going to make the situation worse if anything.

Stipp: What's your take on the overall valuation levels of the Chinese market given that we have seen some sell-off there?

Foster: That's a tricky thing. The Chinese market now is so vast, it's hard to put a quick descriptor over its valuation, because there are pockets of the market that were frankly incredibly overvalued by any reasonable measure in the middle of June. And those parts of the market have seen the most severe sell-off in recent weeks.

But there were other parts of the market that I would say weren't necessarily terribly overvalued to begin with--and perhaps even reasonable or cheap, in my view.

I would say that definitely the selling pressure has surfaced some real values, because people are being forced mechanistically to sell, and that means that they are not being very discriminating about the prices at which they sell. So, I think some bargains are already emerging in the marketplace.

It's important for your readers to also know that the Chinese market has two major segments to it. There is an onshore, domestic market called the "A share" market, which is only available to Chinese citizens for the most part; some foreign funds can invest there, but very few still. And then there is an offshore market that's listed via Hong Kong, and that's the main way that most investors in the U.S. would have exposure to China, and those markets are very different from one another. It's the A share market that we're discussing now that is seeing these sharp rallies and declines. The offshore market in Hong Kong has followed suit, but nowhere near to the same extent. It hasn't had the same pressure on the upside or on the downside. It's had some, but not the same wildness.

Stipp: We have seen the U.S. market sell off--obviously not as severely--because we've seen troubles in China. What's your take on the risk of contagion in the Asian markets or elsewhere around the globe?

Foster: I do have fears, because frankly, contagion is really driven by fear. It's very rarely a mechanistic or a factual sort of situation. It's really fear begetting more fear and having it spill across markets. There are already some signs that this is taking place. The one market that I can identify that might have a direct follow-on effect from China's current weakness is the commodities markets. Not necessarily energy, but raw materials may suffer from what's going on in China, especially if it begets a broader economic slowdown.

Stipp: As a U.S. investor, how should I think about what's happening in the Chinese stock market, and potentially with the Chinese economy? What should the big takeaways be for us?

Foster: I know it may sound strange, but I wouldn't be terribly worried as yet, because the stock market in China just doesn't hold the same degree of importance for the Chinese economy as does our stock market in this country.

If we saw this sort of volatility and this sort of rise and fall in the stock market here, we'd be quite panicked. But the Chinese stock market just isn't as important a conduit of finance for companies, nor is it as major a reservoir for savings and investments for households. There are definitely those who have exposure, and they are being hit hard right now. But I don't think it will have the transmission mechanism to slow down the economy the same way it might in the United States.

There is an important caveat here, though. I mentioned that the Chinese government was seeking to clean up its major state-owned enterprises and sell them off at better prices, and this sort of stock market action may put a damper on those plans, and those plans were very critical to ensuring that China's growth rates stayed higher.

So if the Chinese government loses the resolve and will to push ahead with its reform plan for the state-owned enterprise sector, which is a very large and not very well-managed part of the Chinese economy--if it is not cleaned up because people lose the drive to do so, then I think we could be seeing a longer-term effect spill over to the Chinese economy that would be negative.

Stipp: Andrew, always great to get your insights on the Asia region, and today on China specifically. Thanks so much for calling in.

Foster: Thanks so much, Jason.