Shanghai: As global equity investors reel from the biggest sell-off in two years, nowhere has the pain been more acute than in China and Hong Kong.

Benchmark indexes in the world’s second- and fourth-largest stock markets have fallen faster than any of their major peers since the global rout began late last month. With losses deepening on Friday to more than 11 per cent, both markets were poised to snap their longest-ever streaks without a 10 per cent correction.

The sudden tumble, China’s worst since its 2015 market collapse, has shocked investors who had grown accustomed to the steadying effect of government intervention over the past two years. But after guiding the Shanghai Composite Index to its calmest bull market in history, authorities are now showing a higher threshold for losses as they seek to snuff out moral hazard and reduce risk in the nation’s $16 trillion (Dh58.7 trillion) shadow-financing system.

The big question is whether stocks are now signalling trouble ahead for the world’s second-largest economy. Most analysts are still sanguine, with the consensus growth estimate holding steady at 6.5 per cent for 2018. Optimists point to the corporate bond market’s relative resilience over the past two weeks and a yuan that still trades near its strongest in two years against the dollar, despite losing some ground in recent days. Investors aren’t yet showing signs of 2015-style panic.

Still, market declines in China have a habit of snowballing. Many observers are braced for more volatility as liquidity conditions tighten before the Chinese New Year break that starts next week. On average, declines of 10 per cent or more in the Shanghai Composite have lasted two months before a reversal of the same magnitude.

“We are still in the depth of market volatility as sentiment was hurt by the double whammy of US market turmoil and deleveraging efforts at home,” said Wu Kan, a Shanghai-based fund manager at Shanshan Finance Co. “Risk appetite has dropped sharply and I don’t think the situation will get any better before the Chinese New Year holiday.”

The Shanghai Composite sank as much as 5.8 per cent on Friday, before paring some of its retreat to trade 4.1 per cent lower at 3,128.25 as of 1:01pm local time. Hong Kong’s Hang Seng Index lost 3.2 per cent, while the Hang Seng China Enterprises Index of mainland companies in the city slumped 4.1 per cent. The yuan weakened 0.16 per cent to 6.3288 per dollar in onshore trading.

Before losses in Chinese stocks shifted into high gear on Tuesday, the market seemed like it would become a haven amid the global storm. The Shanghai Composite rose 0.7 per cent on Monday, brushing off a tumble in US stocks that had sent the S&P 500 down more than 2 per cent last Friday.

Shadow banking

China’s equity market has always been somewhat insulated to global swings due to the country’s capital controls, and it has been unusually stable since Liu Shiyu took over as chairman of the China Securities Regulatory Commission with a mandate to rein in volatility in February 2016.

But the Chinese market has also grown more integrated with the global financial system in recent years after the opening of cross-border trading links with Hong Kong, making it more susceptible to turbulence overseas.

“Slowly but surely Chinese markets have become more connected with the rest of the world, so when you have a strong sell-off in the US, Europe and Japan, increasingly you’re probably going to see more reaction also taking place in mainland China,” said Stefan Hofer, Asia chief investment strategist at LGT Bank AG in Hong Kong.

Opinions differ on the triggers for the global sell-off — analysts have cited everything from rising bond yields to inflated valuations and hedge funds selling out of arcane positions — but one factor that has almost certainly weighed on Chinese shares is the government’s deleveraging campaign. The clampdown on shadowy wealth-management products has siphoned money from the equity market, pushed up corporate borrowing costs and raised the spectre of rising defaults.

While authorities would likely ease up on the crackdown if the market slump spirals into a crash, Jinkuang Investment Management’s Zhang Haidong says losses in stocks aren’t yet deep enough for the so-called National Team of state-run funds to ride to the rescue. The Shanghai Composite trades for 16 times reported earnings, 7 per cent higher than its five-year average, according to data compiled by Bloomberg.

“The market doesn’t look like it needs the helping hand of the National Team as it did back in 2015,” said Zhang, a Shanghai-based fund manager at Jinkuang Investment. “It’s still a rational correction after accumulated gains.”