Five things investors need to watch in China

Deepening concerns over the health of China's economy have sent the Shanghai Composite on a rollercoaster ride this week. And there may be more pain to come.

China's pile of cash

China's central bank foreign exchange reserves continue to drop - falling by a record $108 billion to a nearly three-year low in December. The decline in China's cash pile concerns investors because it tells them that capital outflows are accelerating, which puts downward pressure on the currency and increases the need for the central bank to step in and support the yuan.

Goldman Sachs wrote this week that the potential for further capital outflows is large, especially if the devaluation of the yuan continues apace. The amount of capital leaving China has been rising at a fast pace ever since China surprised investors in August with a surprise yuan devaluation.

Mark Williams, chief Asia economist at Capital Economics, says fears of a weaker currency, lingering jitters over the health of China's economy, and Chinese President Xi Jinping's anti-corruption crackdown have all contributed to Chinese investors taking money out of the country. Experts predict that a major priority for the Chinese central bank will be to cut into the amount of money flowing overseas.

Restricted sales by big shareholders

A ban on stock sales by large shareholders that was implemented in July of last year was supposed to end on Friday. However, given recent market volatility, Chinese regulators announced (on their website) that investors who own holdings of 5 per cent or greater of shares outstanding won't be allowed to sell more than 1 per cent of total shares outstanding within the next three months. The extension of the ban is widely seen by China watchers as a near-term positive, as it reduces the likelihood of large investors reducing their positions.

In the long term, however, analysts see the stock ban as a negative, saying it illustrates the Chinese government's continuing willingness to intervene in the market. China has been criticised for its consistent interference, especially during last summer's markets meltdown, when regulators implemented a series of measures to limit wild swings in stocks.

Investment bank NSBO wrote in a note on Wednesday that as long as the market fears that large sales are coming, it creates an overhang on the market, while the continuation of government restrictions further dampens already weak international investment sentiment.

Circuit breakers: In, then out

So-called circuit breakers, which are designed to stop prices from free-falling by putting a halt on trades, were introduced to the Chinese stock market for the first time on Monday of this week. It didn't take long for them to be tested - they've kicked in twice already. In fact, some traders say the mechanism should be blamed for the sharp sell-off.

On Thursday, Chinese regulators announced the temporary suspension of the circuit breaker. The China Securities Regulatory Commission said in a statement that it was doing so in order to maintain market stability. Experts expect China to go back to the drawing board and tweak the circuit breakers before reintroducing it to the public market. In a note to clients on Thursday, Teneo Intelligence predicted that Chinese policymakers will continue a trial-and-error approach that takes its cue from short-term market events.

Deflationary fears

The United States, Europe and Japan are not the only economies that are dealing with low inflation. Add China to the list. On Friday, economists will get a better sense of how the world's second-largest economy is battling deflationary fears. China's November consumer price index rose by 1.5 per cent year over year, while China's producer price index dropped nearly 6 per cent. The fall in producer prices marked the 45th consecutive month of price deflation, due in part to ongoing weakness in manufacturing activity and sluggish demand.

"Falling product prices and profit-squeeze makes it harder to deleverage corporate debt and get investment going again," said Duncan Wrigley, who specializes in China macro research at NSBO.

However, there are some optimists out there: Capital Economics says that inflation data expected this weekend should provide a respite from fears that China's economy and financial markets are collapsing.

"We foresee another rise in consumer price inflation, which should further dampen concerns about deflationary pressure," wrote Chang Liu, China economist at Capital Economics.

Currency troubles

The People's Bank of China fixed the yuan lower for the seventh consecutive session, heightening concerns among investors that the central bank will push the currency even lower. A lack of transparency around China's approach to its currency is casting a shadow over China's story. The yuan lost 5 per cent against the US dollar in 2015, and is off by 1 per cent in the first week of this year. Traders were expecting further deprecation in the yuan in 2016, but not so sharp a decline as they've witnessed over the past couple of days.

In a note on Thursday, UBS analysts said they expect the yuan to depreciate by 4-5 per cent against the US dollar this year, and they said they think that it likely will do so sooner rather than later. Others see steeper falls: Thierry Wizman, currency strategist at Macquarie Group, expects the yuan to weaken by 8 per cent against the dollar in 2016. Weaker currency is bad news for US and European corporations that do business in China, as its makes their products and services less competitive.

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