Making sense of China’s huge stock market selloff

The recent sharp selloff in Chinese stocks on the back of a very positive economic policy package from Beijing seems irrational.

Chinese investors have been agitated by domestic authorities’ proposal to implement the so-called “circuit breaker,” a mechanism designed to halt trading if stock prices gyrate too wildly in both directions. Investors collectively responded to the proposal by selling down the stock market by 7% on the first trading day of 2016.

It is not immediately clear why a mechanism that presumably protects investors would cause a rout in the marketplace. Some say it was the disappointing manufacturing data that triggered the selloff, while others speculate the panic was brought about by the expected end of a selling ban on large Chinese institutional investors. Whatever the reason, the panic selloff seems to be irrational.

There is no question that the Chinese economy is soft. Nevertheless, this is no longer news for financial markets where stock prices already have discounted the soggy economic picture. Indeed, last month’s manufacturing PMI print was slightly below market expectations, but a wide range of indicators suggest the Chinese economy is stabilizing and may even be strengthening. Credit creation is picking up, both broad and narrow money growth is accelerating, and real estate prices are slowly turning higher. Private consumption continues to grow at a robust pace, with retail sales growth advancing at 11%. Nothing would suggest a sudden deterioration in the underlying economy.

(Related read: China equity exposure expected to increase in 2016)

Most importantly, the Chinese government has recently rolled out its economic policy blueprint for 2016. In a nutshell, Beijing is preparing to tackle the economic slowdown on two fronts. On one hand, the Chinese government has made it clear that policy stimulation will become more “forceful” than before, with public sector spending being scaled up substantially and more interest-rate cuts in the pipeline. These policy initiatives are aimed at stimulating aggregate demand in order to stabilize economic growth.

On the other hand, the government is preparing aggressive “supply side” reforms, including corporate tax cuts, shutdown of overcapacities, and elimination of “zombie” corporations. These reform measures—if implemented—will be very bullish for the Chinese economy over the long term, although short-term pains could be possible.

History has shown that stock markets usually embrace supply-side reforms with rising prices. This is because supply-side reforms usually lead to a more efficient economy with improving corporate profitability, stronger growth, and increasing resilience.

In this vein, the recent sharp selloff in Chinese stocks on the back of a very positive economic policy package from Beijing seems to be irrational. With the so-called Chinese H-shares, which are Chinese companies that are listed in Hong Kong, trading at a P/E ratio of 5-6 times, I would regard the New Year selloff as creating a good buying opportunity. Of course, buying Chinese stocks is not without risks. It looks as if the central bank is quickening the pace of Chinese currency depreciation. Nevertheless, the odds of a major currency decline remain low.

Chen Zhao is co-director of global macro research at Brandywine Global Investment Management, and was a professor at Beijing’s Central University of Finance and Economics. He has served as a senior adviser to several government organizations in the People’s Republic of China.