Bank of America Merrill Lynch‘s China strategist David Cui, a long-time China bear, is out this morning with his views on the heavy selloff in China’s stock markets on Monday.

The CSI 300 Index tumbled 2.4% on Monday, the biggest one-day fall since June 13, providing another reminder to foreign investors how volatile China’s markets can be. The selloff was sparked after the Chinese government cracked down on insurance companies buying stocks. For more details, see my yesterday’s blog “UPDATE China Stocks Tumble As Beijing Clamps Down On Insurance Buying“.

At issue is the so-called “universal” insurance, a type of life insurance policy that also promises investment returns. Some even “guarantee” 6-7% returns and the minimum investment can be as low as just 1,000 yuan, a level which is accessible to China’s middle class. As a result, insurance companies used a lot of leverage to buy blue-chip stocks to obtain those sort of returns.
But China bear Cui questions whether Beijing’s crackdown on “universal” insurance will have much of an effect on China’s stock markets given the impact of the stock purchases by insurers is simply too small:
Despite some high-profile single-stock purchases by insurers in recent quarters, their impact on the overall A-share market should be fairly moderate – we estimate that ULIP-funded stock positions accounted for 0.6% of the total market as of 3Q16.

Since mid-2014, insurers’ ownership of A-shares has only risen slightly, from 2.4% to 2.8%, despite some aggressive stock investment moves by some small/mid-sized insurers, often funded by universal life insurance product (ULIPs) sales. It appears to us that insurers are generally not very keen on stock investment, despite the government’s encouragement of such investment.

So what’s the problem?

The problem in China is herd mentality and the prominence of retail investors. Retail investors now own over 40% of China’s A-shares. In addition, many are not sophisticated investors. According to the Shanghai Stock Exchange, about 75% of retail investors in the A-share market do not have college degrees, and only 43% of college degree holders in China participate in the stock market (because they’ve got better things to do!). As a result, retail investors tend to follow the market, so when negative news hits the wires they start to panic and sell. (See chart)

The value of China’s retail investors’ stock holdings track index performance too well, a sign of herding behavior.

Bank of America Merrill Lynch
China’s A-share markets continues to trend lower today. The CSI 300 Index was down 0.3%. Overnight, the Deutsche X-Trackers Harvest CSI 300 Index China A-shares ETF (ASHR) fell 3.3% and the iShares MSCI China ETF (MCHI) dropped 2%.