Hang on to China – there are more gains to come

On Friday, China caused a bit of a stir in global markets not least its own when it made short-selling easier and using borrowed money to buy stocks harder.

The message seemed clear "Watch out stocks can go down as well as up".

Yet on Sunday, it announced the biggest loosening in monetary policy that we've seen since the financial crisis. That would normally result in higher stock prices, all else being equal.

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So are China's authorities losing it? And what does it mean for your Chinese investments?

Bullish or bearish? China's regulators can't make up their minds

On Friday, Chinese regulators said they would allow fund managers to lend out shares for short-selling. It also cracked down on some forms of margin financing that is, borrowing money to buy shares.

Investors buying stocks with borrowed money have been a significant driver behind the massive Chinese stockmarket rally. Speculators have turned from the real estate market to the stockmarket, opening up new betting accounts at a rate of knots. Putting a stop to that suggests there will be less money available to flow into the market.

Meanwhile, allowing perhaps even encouraging short-selling also sends a signal to the market. Allowing people to profit from a drop in share prices is a reminder that share prices can fall as well as rise.

In all, the news is a bit of a reality check for investors who believe that Chinese stocks can only go up.

Yet, on Sunday, there seemed to be a bit of a U-turn. The Chinese central bank (the People's Bank of China) cut its reserve requirement ratio (RRR). The RRR dictates the amount of cash that China's banks have to keep stashed with the central bank.

The higher the RRR, the more cash they have to keep in their reserves, and the less there is to lend out. The lower the RRR, the more cash they have free to lend to customers.

So it's a bit like when the Bank of England cuts the key interest rate in Britain it should lead to more lending and ultimately more growth (or at least inflation).

The reduction was pretty significant a full percentage point, taking the RRR from 19.5% to 18.5%. That's the biggest such move since 2008. As Mark Williams of Capital Economics put it: "We see it as signalling a shift to a more supportive policy stance".

In short, the Chinese authorities are getting a bit worried. Economic data has been pretty weak during March. That might just be to do with disruption related to Chinese New Year. But, as Williams notes, "the downside risks to growth appear greater now than they did a month or two ago."

So what's going on?

Fresh money has to find itself a home somewhere

This might all seem quite contradictory, but it's worth considering the dilemma the Chinese authorities face. The Chinese stockmarket has rallied sharply. It's clearly bubbly in several areas and there's a lot of speculation going on.

Trouble is, at the same time, economic growth is weakening. This is all part of the overall plan a desire to make China more dependent on consumer spending rather than manufacturing. But it's a tricky juggling act. If economic growth slows too much, people won't have jobs, and there'll be no money to spend.

So the authorities want to encourage more money to flow around the system. They want banks to lend to businesses, and for businesses to expand, and to create more jobs, and for employees to spend their money, encouraging businesses to expand further, etc etc.

But they don't want all of that extra money to just flood into the stockmarket where it won't really do much apart from drive up asset prices, increase inequality, and pose a threat to the entire economy when, and if, it eventually crashes.

So what can you do? You crack down on the worst of the speculative excess by encouraging the short sellers and discouraging the punters who want to use the market as a casino. You might not get the balance right but it's the best a central planner can do.

That said, this RRR cut will pump a lot of new liquidity money into the economy. And as we've seen from the experience in just about every other country in the world, when you force more money into an economy where businesses are reluctant to borrow and banks are reluctant to lend, well, the money has to go somewhere. And that somewhere often ends up being the stockmarket.

Moreover, the RRR still has plenty of room to come down. As Gavekal Dragonomics notes on Reuters: "Real interest rates are extremely high" in China. So there's lots of room for more stimulus'.

The Chinese market is up by more than 80% since November. Yet as Capital Economics' Williams puts it: "As long as policymakers are still easing, it is hard to see the rally petering out any time soon".

So we'd hang on to China. There are various ways to invest, but one simple option for British investors is the JP Morgan Chinese investment trust (LSE: JMC). It currently trades on a discount to net asset value of 15% or so.