Be prepared for more shocks from China's frothy stock markets

ON THURSDAY, China's stock markets tumbled about 6 per cent, their biggest daily decline in four months. Could this be the start of the deflation of what many commentators consider to be a stock-market bubble?

Since mid-2014, China's stock markets have been on a tear. This year alone, and even after Thursday's fall, the Shenzhen Composite index is up about 94 per cent, while the Shanghai Composite index has risen 43 per cent. The dizzying rise is out of sync with what is going on in China's economy. The economy has been slowing, with growth last year coming in at 7.4 per cent, the slowest pace since 1990. The slowdown has intensified into 2015. Some economists reckon that if reported on a quarter-on-quarter annualised basis, growth in the first quarter of this year is running at around 5.4 per cent. However, the stock market and the economy do not necessarily move in tandem. For instance during many of the years of China's heady growth, including the five years to 2014, China's stock-market performance was lacklustre.

So what has driven the current stock-market boom? One factor is certainly the monetary loosening by China's central bank, which has cut interest rates three times since November, thereby releasing massive liquidity into the economy. Second, a lot of other investment opportunities for mainland Chinese investors have all but dried up. Trust products are no longer popular after many of them ran into trouble in recent years and the real-estate markets in many cities are moribund. Stocks - which were arguably undervalued until the middle of last year - were, for many investors, the only game in town. For companies, equity also became an attractive way to raise funds, as credit markets in China became tighter. A fourth factor is the increase in margin trading. There are reports that some eight million margin-trading accounts were opened in the first quarter of 2015 - more than at any time in China's history.