Publish date:

China: Worst Yet to Come

Some analysts say financial institutions are most at risk.

A day after shares in China plunged 8.8%, shares on the Shangahi Stock Exchange rebounded, with the index ending the day up 3.9% at 2,881.07.

But investors in Hong Kong say that the worst is still yet to come, and that the outlook for China's market remains overly optimistic. The Hang Seng ended the day down 2.46% at 19,651.51.

"Equities in China are still much more overpriced than people are admitting at the moment," says Sean Darby, head of Asian strategy at Nomura Bank in Hong Kong. "The Chinese pressure cooker is getting hotter. It hasn't tightened rates that much. There's closed capital account money flowing in and contracting liquidity."

The panic selling Tuesday was brought about by a series of events over the past few days in China that made local investors concerned over the sustainability of the recent bull run, says Michael Spencer, chief Asia economist for Deutsche Bank in Hong Kong.

Last week, the Chinese government announced it was cracking down on illegal share placements on the local stock exchanges and would probably raise interest rates as a result of higher-than-expected inflationary pressures, prompting local rumors about an equity bubble.

Less substantiated speculation going around trading floors in China at the moment include potential crackdowns on mutual fund investment, fluctuations in the capital gains tax rate and a change in leadership at the

Chinese Securities

Regulatory Commission.

After the steep drop in China, a wave of selling surged through world markets. In the U.S., the

Dow Jones Industrial Average

slumped 416 points.

China and emerging-markets-based ETFs fell sharply Tuesday. The

iShares FTSE/Xinhua China 25 Index

(FXI) - Get iShares China Large-Cap ETF Report

ended the day down 9.87% at $95, the

iShares MSCI Emerging Market Index

(EEM) - Get iShares MSCI Emerging Markets ETF Report

TheStreet Recommends

lost 8.13% to 107.90, and the

iShares Singapore Index

(EWS) - Get iShares MSCI Singapore ETF Report

fell to 11.54, down 7.83%.

A research note titled "When China Sneezes Does The World Catch Cold?" issued by Nomura at the end of trading Tuesday concurred with the gloomy outlook, while blaming in part the recent global appetite for risk.

"We do not see a simple causality between the performance

Feb. 27 of Chinese equity markets and global markets. Global risk appetite has been intense, while technically global markets were overbought. We expect an ongoing reversal in risk appetite to undermine Asian equity prices in the short term. Based on a number of financial measures, investor risk appetite appears almost insatiable," said the note.

The note also said that Nomura expected growth fears about the U.S. economy to resurface. The question on the minds of traders in Asia was whether the selloff will remain confined to China or spark a long-term contagion elsewhere in the region and eventually the rest of the world.

Spencer says it was the early Japanese reaction to China's initial selloff that began the reverberations felt around the rest of the world.

"There's only $9 billion of foreign investment in China -- it's nothing -- but the Japanese viewed this as a broader global phenomenon and then took action which subsequently re-enforced this idea," he says. The panic subsequently spread "from China to Asia to the yen, and then to the rest of the world, but there's no particular reason why. It's bizarre."

The sector seen as most at risk by Asian analysts is financial institutions, in particular those with Chinese exposure, because of the new uncertainty over loose monetary policy there. Big fees generated from Chinese mega-IPOs last year are also likely to dry up, which could affect some international investment banks.

Last year, UBS co-managed the $9.8 billion IPO of Bank of China along with Goldman Sachs; more recently, it was hired to help with the flotation of China Railway Engineering Group and Wuyi International Pharmaceutical. UBS also took a $500 million stake in Bank of China earlier this year.

Spencer says that it will take a long time for a proper recovery to materialize.

"This started a little earlier than we expected, but markets in China and India will continue to sell off another 10% to 15% now for the next three to six months, and then they'll go sideways for the next couple of years," says Spencer. "It will be a slow recovery from here."

Harrison is a business journalist specialising in European and emerging markets, in particular Asia. He has an MBA from BI, Norway and a blog at

. He lives in New York.