China stock crisis: Why comparisons to Greece may be 'overdrawn'

While Greece's financial troubles were stealing the international spotlight, China was dealing with a stock market that had lost $3.2 trillion of equity in a few weeks, more than Canada's entire GDP output for the year.

The dramatic plunge sparked some observers to note that the real crisis, the one the world should really be focusing on, is China's market woes and the threat of contagion — the possibility of the turmoil expanding to Asian markets and maybe the U.S. and Canada.

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"At this point, I think it's 60/40 against it spreading materially to the Western markets," said William Gruver, a professor of management practice at Bucknell University in Pennsylvania. "But earlier this week and last week, I would have had it 90/10 against."

Gruver said he initially wasn't that worried about the plunge, that is until it seemed to spread to the more sophisticated markets of Hong Kong. Now he's concerned the market turmoil in China at this "early stage of the collapse" is very similar to the Western financial meltdown in 2007. 

More than 25 per cent has been knocked off the value of Chinese shares since mid-June. To put the $3.2 trillion amount in some perspective, Canada's entire GDP for 2014 was slightly less than $2 trillion.

But Loren Brandt, an economics professor at the University of Toronto who specializes in the Chinese economy, said the immediate impact on China will likely be relatively modest.

"The comparisons with Greece are overdrawn."

Beijing's response

​Beijing has responded with a battery of support measures, including an interest rate cut, suspension of initial public offerings and enlisting brokerages to buy stocks, backed by cash from the central bank.

And by Thursday, China's markets had rallied back. By the close of trading. the CSI300 index of the largest listed companies in Shanghai and Shenzhen had raced up 6.4 per cent, while the Shanghai Composite Index bounced 5.8 per cent, its biggest daily percentage gain in six years.

The market volatility can be explained in part by the composition of the investors, which differs significantly from North America. 

About three quarters of the volume in the U.S and Canada stock market is traced to institutional investors who arguably are more sophisticated than retail investors, Gruver said. But just the opposite is true in China, where 80 per cent of the market is driven by retail investors who have come into wealth relatively recently.

"Not only is the market driven by retail, but it' s driven by relatively inexperienced, unsophisticated retail."

That makes the markets more susceptible to human emotion because the majority of the investors are average citizens, as opposed to investment professionals, Gruver said

But to pinpoint the exact reason for the market's decline is as difficult as explaining the rise that began more than a year ago, said Brandt.

"The rise in the market last year was very difficult to make sense of, especially in the context of an economy that was deleveraging and experiencing a declining rate of growth. The question was not so much 'Will the market decline?' as 'When will it correct?' "

Market riding high

It had been riding high over the past year, rising by 150 per cent. This means, as Scotiabank's global economics special report notes, that despite the drop, the Shanghai Composite is still up by more than 80 per cent and the Shenzhen higher by more 70 per cent since the end of last June, when the rallies began.

"It remains premature to call this a bursting bubble of epic proportions with risks akin to the 2007 collapse," Scotiabank said.

Unlike the U.S and Canada, China's stock market is much smaller relative to its economy, meaning it's less vulnerable to a correction, Scotiabank added.

As well, only about 10 to 12 per cent of China's middle class households are investing in the market, said Ian Lee, an assistant professor at the Sprott School of Business at Carleton University in Ottawa. 

"So it's not as if everybody is in there and they are worried that the whole Chinese population will lose their shirt."

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Brandt also said China's central government is in a very good position fiscally, has huge resources ($4 trillion US in reserves) and assets in state own enterprises (SOE) at its disposal.

Meanwhile, a long list of people would also be willing to lend to China, if it ever came to that.

But the market plunge is symptomatic of deeper problems in the financial markets and economy that have been there for some time. 

"China is likely in for several more difficult years before there are serious prospects of reversal," Brandt said.   Individuals, institutions that invested on margin will be the hurt the most, as will the institutions that lent to them."

According to Scotiabank, likely the largest negative direct effect of a pronounced stock market decline will be a slowdown in initial public offerings. The fear, too, is that further stock market losses will trigger a series of margin calls that push investors to sell equities, depressing the stock market further and snowballing losses, Scotiabank said.

"We're not unconcerned about the macroeconomic effects of correcting Chinese equity markets but not sufficiently worried to view it as hard landing material versus a relatively minor and short-lived drag on economic growth and financial stability."