The spectacular rally in Chinese equity over the past year and the dramatic crash that ensued this month has held everyone spellbound. But a closer look at the manner in which the rally unfolded shows that investors behave in a similar manner, whether in China or in India.

The rally in Chinese stocks was largely driven by expectation that a large inflow of foreign funds would drive up stock prices. In November 2014 China eased the norms for foreign investment into shares listed on the Shanghai and Shenzhen stock exchanges. Foreign investors could buy these shares through a broker in Hong Kong. This move started a rally that took the Shanghai Composite Index up from 2,478 in November 2014 to 5,178 by this June. But contrary to expectations, the rally was not led by foreign investors; in fact their response has been rather lukewarm. It was predominantly domestic investors and speculators who drove the rally. The rally in the Indian market since August 2013 was also similarly based on expectations of the Modi government bringing about a miraculous turnaround in the economy.

All emerging markets seem to set great store by overseas investors. The rally in China gained momentum in the last two months when it became known that China’s A shares listed on the Shanghai and Shenzhen platforms could be included in MSCI’s emerging market index. The rally halted when MSCI postponed the inclusion citing relative lack of transparency.

When markets get into a speculative spiral, prices tend to move far beyond their fundamental worth. Despite a deceleration in China’s economic growth and Chinese companies recording a slowdown in earnings, stock prices have moved higher. New investors have also been trading on borrowed money or using margin funding. The final stages of the Indian bull-market in late 2007 had similar traits with retail trading in equity derivatives increasing to alarming levels.

Deputy Editor and Head of Research

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