Growing volatility in China’s financial markets is leading to uncertainty about the ability of China to rescue Russia’s stagnating economy, especially if this volatility is a sign of future weakness ahead for Chinese economic growth.

Investors monitor displays of stock information at a brokerage house in Beijing, July 15, 2015.  Photo: AP

While the world’s attention has been focused on the slow-motion disaster that is Greece, much more ominous economic news is emerging daily from China. The People’s Republic, the world’s largest economy (as measured by purchasing power parity, or PPP), has had what can only politely be termed “a bad summer.”

The major stock indices have tumbled since their highs on June 12, with the Shanghai market losing 30 percent of its value in a month and a half.

Given the importance of China’s continued growth to a still-fragile global economy, such a precipitous drop has set off alarm bells in the world’s major financial centers. Moreover, the possible slowdown in China could have disastrous consequences for the countries that have come to rely on China as an export destination, such as Russia.

China’s financial markets are more volatile than ever

China’s financial markets are, in many ways, as unique as the economy that it serves.

Insulated from foreign investors (who account for just 1.5 percent of all shares owned), China’s stock market tends to go its own way and is only slightly correlated with other world indices. The players involved are different as well, with stock exchanges driven by individual retail investors instead of large institutional ones.

These facts may mean a higher propensity for volatility than would occur in a market dominated by larger (and more liquid) players.

Indeed, Chinese investors trade much more than anyone in the world, according to a survey from State Street, and far more often than their American counterparts.

This tendency to higher frequency trading has been recently supplemented by a boom in volume, with the size of the investment community increasing by an estimated 30 million new trading accounts in the first half of 2015.

Given these conditions, it was perhaps inevitable that volatility would increase, a fact shown in Figure 1. After long stretches of calm in 2014, volatility in the Chinese financial market has been substantial throughout 2015, hitting new peaks in July.

Figure 1: Volatility in the Shanghai Stock Exchange, June 2014-today

Data from Yahoo! Finance. Volatility is calculated as the square of log daily returns.

The real effects of this increasing volatility are difficult to discern on the increasingly important Chinese economy. At once, we can see some mitigating factors which may make the absolute declines in the market less daunting than they may at first appear.

In the first instance, there is not as broad an exposure to the stock market in China as there is in Western countries: Only about 9 percent of household wealth is derived from stock accounts, in contrast to about 29 percent of the net worth of American households.

This makes China’s capital markets more a source of corporate finance rather than for consumers, an issue for job creation but less of a factor when one considers the pervasiveness of directed credit in the banking sector.

Moreover, while the markets have dropped precipitously, they are still above their opening point on January 1, meaning that Chinese stock markets are up on the year in total over their close at the end of 2014.

 Read also: Should Russia worry about China's stock market crash? 

However, while the real economy may be somewhat insulated from the happenings in the stock market, the financial sector may be acting as a canary in the coal mine for the prospect of future growth.

It is highly unlikely that 30 million new participants jumped into the market simply to get out again when values had declined, meaning that other factors may be at play, including a crisis of confidence in the government and its handling of the economy.

As Mark Fahey and Nicholas Wells note in an analysis of China’s markets, “Many of [the new market entrants] were buying stocks with borrowed money with the implicit understanding that the Chinese government would not allow the market to crash.”

Given the exposure of these new players, their experience may have led them to understand that the Chinese government could not actually prevent a crash.

These self-reinforcing expectations may have contributed to a herd mentality when things started to go south; bad news, as the economics literature has shown time and again, has much more powerful of an effect on equities than good news.

Indeed, the spiral of expectations in China has shown that the government is impotent when it comes to financial meltdowns, a trait that is only going to become more pronounced as stock ownership spreads. In fact, the real threat to the Chinese economy in the future may come not from the financial volatility as investors learn how to behave in capital markets, but from the Chinese government’s heavy-handed and disproportionate response to stock market declines.

Over the past month, the Chinese government has become a huge investor in the stock market, as the quasi-government China Securities Finance Corp borrowed a mind-boggling 1.22 trillion renminbi from commercial banks to buy stocks as of July 13.

Coupled with a long laundry list of other interventions, including the outright ban of sales for investors and a suspension of IPOs, the Chinese government has gone “all-in” to prevent further declines. But even these drastic measures have not slowed the descent, as China’s main indices continued their drop this week, with the Shanghai markets falling by 8.5 percent on July 27 alone.

Given the uneasy hybridization of China’s economy, with political repression existing uneasily alongside great wealth, the financial turmoil this summer may signal that the balance is starting to shift.

The economic forces that Deng Xiaoping unleashed in 1978 have always been in conflict with the Communist desire for control, and financial markets present the greatest obstacles to the planner’s dream of controlling everything.

The events of the past month, especially the government’s response, show perhaps that Communists are not the best choice to be stewards of a capitalist economy.

The impact of China’s financial woes on Russia

If the impact on China is uncertain, the impact on Russia is less ambiguous, as all signs point to trouble ahead.

China’s financial gyrations could not come at a worse time for Russia, which is already experiencing its own recession and has no prospects of breaking out of stagflation in the near future.

Russia has been relying on the sheer political weight of China to give backing to the BRICS project, hoping that this loose grouping of countries can provide a counterweight to what is perceived as “Western” values.

However, Russia was never powerful enough economically to provide a counter to the EU, much less the United States, and thus needed China to make the BRICS somewhat credible as an alternative.

With China’s stock market in freefall, there is even less of a chance that the BRICS can somehow represent a viable development path for other countries. When combined with Russia’s stagnation, Brazil’s economic collapse, and South Africa’s warning signs, the last thing the BRICS need is for China to also implode.

 Related: Russia Direct Brief: 'BRICS 2.0 and the metamorphosis of globalization'. 

Beyond some nebulous (and poorly thought out) development model, worse still for Russia is the direct effect that a slowdown in China will have on its economy. While the Chinese market only accounts for 6.8 percent of Russia’s exports and 17 percent of Russia’s imports according to the WTO, trade has been on an upward trend since 2009.

Perhaps more threatened is the flow of investment from China to Russia, an issue that was championed by Chinese Vice-Premier Zhang Gaoli in his much-publicized trip to Russia in June.

China accounted for 6.1 percent of all foreign direct investment (FDI) in Russia in 2014 according to data from the Central Bank of Russia, a number that has risen as Russia has been isolated from Western capital markets and investors.

In the heady days of early May, there was even talk of increasing official Chinese investment by 150 percent over the next 5 years.

However, this goal now seems optimistic given the uncertain future of China’s own markets, a reality reflected in the fact that Chinese investment in Russia fell 25 percent in the first half of 2015. The total effect of the past two months of volatility in China may thus not be to directly shake the Russian economy, but rather to add more evidence that Russia’s path is unsustainable. 

Of course, there are mitigating factors for Russia in China’s economic panic as well, although they will be of cold comfort for the Kremlin. 

The biggest factor is that Russia’s economic issues are mainly internally generated, and China’s downturn has little additional impact on a stagnation that is the result of Moscow’s own policies.

 A corollary to this regards the fact, as noted earlier, China is de-coupled from world stock markets, which also includes Russia.

Figure 2 shows the performance of the Russian and Chinese stock markets over the past year, and their performance is driven by internal factors rather than each other, meaning little risk of contagion in this particular episode.

 Figure 2: The Moscow Interbank Currency Exchange (MICEX) and Shanghai Stock Market Indices, June 2014-today

Source: MICEX Stock Exchange website and Yahoo! Finance.

And finally, as noted earlier, trade and investment from China have been on an upward trend but still remain low in absolute terms, meaning a drop back to 2013 levels could still be sustainable. However, the difference this time around is that Russia needs China more, given the closing of Europe to 'the stumbling, bumbling bear'.

The political repercussions of financial volatility

The financial volatility in China may point to deeper weaknesses in the Chinese economy, as well as the inevitable diminishing marginal benefits of China’s hybrid economy.

Simply put, China’s economy threatens to be bogged down under corruption, bureaucracy, and political direction, all inherent features of China’s Communist Party.

While these are all longer-term threats, the volatility in the stock market is a reflection of a growing disillusionment with the Party’s ability to cope with such issues.

In this sense, China’s stock markets are reflecting the same unease that can be found in investors in Russia today: Can this leadership stop the economic slide that our country is in? And, as in Russia, despite what the man or woman in the street may tell the opinion pollster, investors have been voting with their money.

The opinion of the author may not necessarily reflect the position of Russia Direct or its staff.