Meltdown in China Stocks May Get Worse

CNBC

China stocks suffered wild swings for a second straight day as heightened fears over a cash crunch in the world's second largest economy continued to batter investor sentiment.

The Shanghai Composite Index finished 0.2 percent lower Tuesday on hopes of intervention by the central bank, but not before plunging as much as 5.7 percent earlier in the session.

After the market close, the China central bank sought to reassure markets, saying that the seasonal factors leading to tight liquidity will fade and that the bank will guide market rates to reasonable levels.

Despite the reassurance, market strategists say the carnage for the market, which has fallen almost 20 percent since its peak in mid-February and now trading at its lowest level in four years, isn't going to stop here.

(Read More: It Is Now the China Bear's Turn to Maul Markets )

"There will be further downside risks in the short-term, because the government is not likely to ease liquidity constraints. It's going to restrict credit growth. They want to send a very strong message to the small and medium banks to manage their liquidity," said Kelvin Tay, regional chief investment officer, Southern Asia-Pacific at UBS Wealth Management.

Tay forecasts another 5-8 percent downside in the Shanghai Composite from current levels in the coming days.

Domestic investors - which account for around 80 percent of market turnover, have been leading the selling in stocks, according to market watchers.

"One reason we still see pressure in the A-share market [or Chinese companies denominated in yuan listed in the mainland] is because people have to take funds out of the equity markets and find channels to plug [funding] holes as we get to the end of the [earnings] reporting period," said Erwin Sanft, head of China and Hong Kong equity research at Standard Chartered.

The seven-day repo rate - a gauge of the availability of funds in the interbank market - saw wild swings on Tuesday, trading between 6 percent and 16 percent, according to trading firm IG Markets, much higher than the one-year average of around 3 percent.

This has created stress among small to medium sized banks which source a sizable portion of their funding needs in the interbank market. Shares of these banks were sold off, with China Minsheng Bank and China Merchants Bank down 4-6 percent.

(Read More: China Cash Crunch Already Being Felt on the Ground )

Kelvin Chan, head of country research for Euromonitor says, while the People's Bank of China is doing the right thing in disciplining lenders, investors in mainland equity markets are going to have a hard time.

"One thing is for sure, China will have a slower rate of growth for the next couple of years. So as a result of that, with all this uncertainty we are advising our clients to be very defensive," Chan said.

How Bad Will It Get?

While strategists aren't ruling out further selling in the equity market, they are not anticipating a crash in the market.

"At the end of the day, valuations will always play a part, if it gets to a certain level where it becomes ridiculously cheap the QFII's [Qualified Foreign Institutional Investor] will increase their weightings on Chinese equities. And on top of that you have the government holdings and pension funds that will support the market also if they want to," said Tay of UBS.

"I don't' think it will collapse," he added.

Chen Jiahe, analyst at Cinda Securities, in fact, advocates picking up Chinese stocks right now.

(Read More: Mobius: China's Problems as Big as US Subprime )

"The market is overacting I believe it is an excellent opportunity to pick up blue chip companies. Frankly, the Chinese economy is still healthy and valuations are still cheap. This is time for bottom fishing in the long term," Chen said, noting that A-shares are trading at the cheapest price to book ratio on record at 1.3

By CNBC's Ansuya Harjani



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