Chinese stocks suffered their worst one-day drop in 17 months on Thursday. Despite what you may think, this could be a good thing for investors in emerging markets.
Volatility is the flip side of higher returns. It's why investors in riskier enterprises expect better results, on average, than people who pour money into safe, boring businesses.
So investors in China, or emerging markets in general, shouldn't see the 3-per-cent drop in the CSI 300 as a portent of inevitable doom. When it comes to investing in these markets, volatility isn't a bug. It's a feature.
To be sure, if the decline were to extend into next week, it could signal the start of another major bout of risk aversion. The last such episode occurred in January, 2016, when anxiety over China's economy spooked investors worldwide and dragged down stock markets and commodity prices around the globe. But, for now, it's easier to read the market slide on Thursday as a positive sign.
The immediate culprit behind the stock-market retreat wasn't a torrent of bad news, but Beijing's very deliberate campaign to rein in some of the loonier sectors of the national economy. Regulators are trying to crack down on runaway lending in multiple ways, such as restricting banks' ability to buy bonds with borrowed money and reducing the ways for banks to extend off-balance-sheet loans to companies.
In one sign of the changing attitudes, the Shanghai stock exchange criticized an investment bank this week for what it said was an unrealistically optimistic report on Kweichou Moutai Co., the country's biggest liquor maker, which had seen its stock double over the preceding year. This, too, seems to be part of the government effort to cool off speculative fever.
Enthusiastic investors have driven up the price of many large Chinese stocks over the past year. But by comparison with past episodes, such as the great boom-bust episode of 2015, the recent gains in Chinese stocks appear to have roots in reality.
The CSI 300 index, which tracks the biggest companies on the Shanghai and Shenzhen exchanges, has gained 24 per cent this year. However, it still trades for just less than 17 times earnings, according to Bloomberg. To put that another way, the Chinese index, as a whole, is significantly cheaper than the S&P 500 in the United States, trading at 22 times earnings.
The main concern today is whether the stock-market decline on Thursday signals any wider concerns about China's economy. In recent weeks, Zhou Xiaochuan, Governor of the People's Bank of China, has warned of the risk of a sudden collapse in asset prices following years of rampant optimism and exuberant borrowing.
Growth is already gearing down. China's gross domestic product swelled at a 6.6-per-cent annual clip in July but slipped to a 5.2-per-cent pace in October, according to Capital Economics, which derives its estimates by monitoring several signals of economic vitality. Growth in electricity output fell in October, as did gains in the volume of sea cargo moving through Chinese ports.
"China's economy is starting to slow after a period of rapid expansion," Chang Liu of Capital Economics said in a report on Thursday. "We think the slowdown will continue over the months ahead."
But all that being said, Capital Economics still forecasts growth of 5 per cent a year in China's economy in 2018. By comparison, Canada and the United States will expand at less than half that pace, according to International Monetary Fund projections.
The optimistic view is that China is making necessary and overdue adjustments to restrain the country's boisterous accumulation of debt, which has soared from an estimated 162 per cent of the economy's size in 2008 to about 260 per cent now.
Of course, reining in borrowing comes at a cost. The recent regulatory moves helped to briefly drive the yield on the benchmark 10-year government bond above 4 per cent on Thursday. The higher yield reduces the attractiveness of stocks.
But if Beijing is intent on wringing complacency out of the market – and that appears to be its intention – a reminder of possible risks, such as the dip on Thursday, may be exactly what it wants to see. If the turmoil is contained, and prevents future financial bubbles, this would be a good thing, both for China and for foreign investors.