China's Stock Market Isn't Out of the Woods Just Yet

The rebound of Chinese stocks Thursday shouldn't lull global investors into a false sense of complacency: That country's equities market isn't out of the woods quite yet. In addition to stabilizing prices and sustaining a gradual price recovery process, the government must take on the challenge of restoring normal functioning to a market roiled by share suspensions and manipulation.

Given the significant economic and financial links between the two countries, what happens in China matters more to U.S. investors than the spillover from the tragic Greek crisis.

Here are the five considerations for U.S. investors as they monitor developments in China:

1. Chinese equity prices are experiencing a classic market correction that follows a huge over-extension on the way up. The recent 30 percent stock market decline has captured the attention of the world -- and it has been a rapid drop -- but it pales in comparison to the impressive rise that preceded it. And the latter stages of the upswing were fueled by the entry of small investors and the concurrent spread in levered long positions. 
2. This turmoil isn't just about the price collapse; it is also about market functioning. One of the most worrisome aspects of the Chinese market correction is its close links to market failures -- from significant share suspensions to extensive direct intervention and manipulation on the part of the government and the brokerages. 
3. The most immediate threats include headwinds to economic growth as a result of the unfavorable wealth effect effect (lower prices leading to a decline in wealth and curtailing consumption), as well as setbacks to China’s financial liberalization process. But this isn't only a matter of economics and finance: The selloff has potential social and political consequences, too. Having joined the party relatively late, many small investors are being particularly hard-hit by the rout, and many are blaming the government for enticing them to invest and then failing to protect them. 
4. Compared with many other countries, the Chinese government has a wider range of instruments to regain control of the situation. Most importantly, it is both able and willing to supplement direct cash injections with administrative tools, such as scaring sellers and banning outright certain market activities.
5. Regaining control is neither costless nor without risk. The more the government interferes directly in the functioning of markets, the greater the costs down the road for the economy, which needs further liberalization measures toward a market system to navigate the country's transition to a middle-income society. 

In sum, unlike with Greece, the U.S., and American investors, are much more exposed to the spillover effects from China. 

An economically damaged China would lower demand for U.S. exports and harm corporate profits. The more China draws on its huge international reserve holdings to support its domestic markets, the greater the risk of pressure on U.S. financial assets that China has invested in. And the bigger the setbacks to market reforms, the longer it will take China to assume its full responsibilities in the global economy.

This post originally appeared on Bloomberg View. 

Mohamed A. El-Erian is the former CEO and co-CIO of PIMCO. He is chief economic advisor to Allianz, chair of President Obama’s Global Development Council, and author of the NYT/WSJ bestseller “When Markets Collide.” Follow him on twitter, @elerianm.