Why China, and not Greece, should make you worry

Despite frantic efforts, the Chinese government has failed to rein in the country’s plummeting stock market. The Shanghai Composite index has plunged more than 30% from its June 5 high, effectively signalling the start of a bear market.

The fall could have been perceived as a stock market correction in a bull market, but for the government’s panic-stricken steps. Measures such as restricting IPOs, banning investors with more than 5% stake in a company and insiders from selling stocks for the next six months, and asking insurance companies and banks to buy shares to prop up the market have only added to the sense of panic.

In another retrograde step, more than 1,400 of the 2,800 stocks listed on the Shanghai and Shenzen exchanges, in a bid to prevent a further sell-off, have asked that trading be halted. These steps, at best, can only postpone the fall. Refraining from artificial props could have helped the market find its natural bottom sooner. The stark contrast in the value of Chinese stocks listed in Hong Kong—popularly known as H shares—compared to those listed in China, reveals that the Chinese market will correct further in the coming weeks.

On a one-year basis, Index H shares are up 7%, while those listed in China are still up 77%. Experts say, in the past few months, China has seen the makings of a classic bubble. “The bubble was fuelled by easing of rules on margin funding (buying stocks by money borrowed from brokerages). It was driven by retail investors who have very little knowledge of the fundamentals of investing but were lured by the high returns, at a time when real estate and bank deposits are giving negative or low returns,” says V.K. Vijayakumar, Investment Strategist, BNP Geojit Paribas.

That bubble has now been pricked. Corrections tend to be very sharp when a debt-fuelled bubble bursts. Just when Indian markets seemed to have shrugged off the ‘Greece scare’, they were greeted by the ‘Chinese scare’. And unlike the situation in Greece, a crash of this magnitude in China is bound to impact global markets, including India.

A continued sell-off in China poses a much greater risk to Indian market than a potential Grexit. This is because the typical interplay between the Chinese and the Indian stock market may not be replicated this time. Usually, whenever one of the two has experienced a slump, the other has benefitted from higher money flows from foreign investors.

“India could suffer from outflows if the sell-off in China continues,” says Vinay Khattar, Head, Research, Edelweiss. Experts say that if China coughs harder, emerging markets, including India, could catch a cold.

Vikas Gupta, Executive Vice President, Arthveda Fund Management, says, “Global investors are not nuanced enough to distinguish between India and China in such an event. If the value of Emerging Market ETFs declines because of China, the resulting sell-off will also affect other emerging markets to some extent.”

Swapnil Pawar, CEO, Karvy Capital, reckons that India could escape unhurt unless the China situation worsens. “If the rout deepens, then it could subdue interest in the entire emerging market basket,” he says.

A slump in the Chinese economy is bound to keep commodity prices benign, which is a big positive for the Indian economy. With domestic inflation already on the lower side, a further drop in commodity prices will help reduce its import bill further and keep inflation subdued. This will increase the room for the Reserve Bank to carry out more rate cuts, which will boost the domestic economy.

Gopal Agrawal, CIO, Mirae Asset Global Investments says, “Since India is a net importer of commodities, any softening in global commodity prices bodes well for its external deficit.” Khattar argues, “It is definitely a big positive for inflation and raises the possibility of more rate cuts, especially if the monsoon also comes through.”

Impact on commodities Since most of the Chinese stocks are held by retail investors in China, there is a fear that the stock market crash may impact consumer sentiment and further reduce the Chinese growth rate. China is the largest consumer of industrial commodities and, therefore, this panic has started spreading to the commodities market, especially metals. Though gold and silver have remained relatively stable during this crisis, experts are still bearish on them because the crash may lead to a jump in the U.S. dollar, which is bad for bullion as well.

“We are neutral to bearish on gold in the short- and medium-term. The gold rally usually occurs when the U.S. gets into trouble. These crises will trigger a strong dollar and, therefore, keep gold subdued in the coming months,” says Kishore Narne, Associate Director, Motilal Oswal Commodities Broker.

The expected weakness in the rupee, however, may cushion domestic investors from this bearish trend in bullion. According to an ET poll of 14 market participants, Indian rupee may weaken to Rs 64.50 to a dollar from Rs 63.50, in the next three months.

In addition to the unhedged positions of local borrowers, the slide may also be due to some kneejerk capital outflows, triggered by global events. Then, platinum, which has crashed more than 6% during the last one month, falling to a 6-year low, is getting battered on both the fronts: low investment demand because of a strengthening dollar and low industrial demand because of weakness in a key economy like China.

Platinum used to quote at a premium to gold, but now trades $126 dollar below it—for 1 troy ounce (approximately 31 grams). So, should investors capitalise on the low prices and shift from gold to platinum? Experts advise against such a move: “Platinum will continue to underperform gold, till there is a global recovery in the auto sector,” says Narne. Impact on stocks As stated before, firms dealing in commodities are likely to suffer. Vedanta and Hindalco have lost more than 20% and 15% respectively in the past one month. “The slump in the Chinese economy further kills any hope of recovery in the commodity prices for domestic metals firms,” reckons Anand Shah, Executive Director and CIO, BNP Paribas Investment Partners.

With domestic metals and mining companies already weighed down by excessive dumping by China and huge interest burden, the situation could worsen. Lower prices will hurt profitability and further affect these companies’ debt-servicing capabilities. Earnings growth estimates for these companies could be revised downward. Already, the BSE Metal Index has been the worst index performer on the bourses, under-performing the BSE Sensex. Stocks of Vedanta, Hindalco, JSW Steel, Tata Steel and SAIL will continue to feel the heat.

There is also a possibility that the Chinese administration will devalue its currency to boost exports and prop up the economy. In this event, companies from certain exportreliant sectors such as textiles and to some extent, electronic goods, will be impacted by cheap Chinese exports. On the other hand, benign commodity prices will help keep input costs for consumption-oriented companies muted. This could aid in margin expansion in these businesses, which could drive up stock prices.

“Companies which use commodities as raw materials will benefit from lower inputs costs,” insists Gupta. Auto, FMCG, paints, chemicals and select auto parts companies are likely to benefit. Automobile manufacturers would benefit from the decline in natural rubber and crude oil prices, while FMCG players will get a boost from decline in palm oil derivatives. The Chinese crisis may also impact companies that have a very high direct exposure to China, especially those entailing discretionary spending. For example, Tata Motors has a lot riding on China. With a 25% contribution to sales of its luxury car business, JLR, China is a crucial market for the company. Its sales are likely to be impacted.

China-focused funds: Not all is lost

The recent correction has already taken a toll on the net asset values of China-focused funds. However, experts advise not to panic and make sudden withdrawals. This is because the recent crash has brought down valuations of Chinese companies listed in Hong Kong (H shares) to reasonable levels now.

“The H shares, which our mutual fund invests in, are trading at a discount to their long-term average,” says Supreet Bhan, Executive Director and Head-Retail, JP Morgan AMC. The price to earnings (PE) multiple of the Shanghai Composite Index, which reflects the Chinese companies listed on the Shanghai stock exchange, is currently at 13.3-times forward PE compared to its 10-year average of 16.1. The MSCI China Index, which includes H shares, is trading at a PE of only 9.2 compared to its long-term average of 11.8 (as on 7 July).

According to Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors: “Had valuations of H shares been very steep, we would have advised investors to exit the market entirely. But that’s not the case at present.”