The Chinese Boom and Bust

This article was co-published by Seeking Alpha on Sep. 13, 2015.

Over the past few months, China’s precipitous stock market drop has been wreaking havoc in markets across the globe. In the middle of June, China’s stock market hit a seven-year peak after surging more than 150% in 12 months. Many analysts had been warning that the rise in the Chinese market was driven by momentum rather than fundamentals, since the Chinese economy seemed to be losing steam. Yet, the dramatic surge in stock prices continued unheeded until mid June, when the market suddenly turned. Since then, the Chinese stock prices have dropped nearly 40% culminating in a one day drop of 8.5% on August 24 which is now being called China’s Black Monday. According to Barrons, top strategists and money managers predict another 15% decline before the market hits bottom.

Shanghai Composite Index performance over 1 year (Source: VOX)
Shanghai Composite Index performance over 1 year (Source: VOX)

Around the globe, fears have been rising as to the potentially catastrophic political, social and economic consequences a financial crisis could have for China, its closest trading partners and the global economy as a whole. In China, individual retail investors directly own the majority of shares and their losses risk hurting the real economy and even leading to social unrest. Therefore, the rapid decline of the stock market has worried the government and president, Xi Jinping, who were already struggling with a Chinese economy that had been losing steam. Having increasingly drawn its credibility from the strength of the stock market, the Chinese leadership has become increasingly desperate in their effort to prop up equity prices.

What was behind the bubble?

The Chinese stock market bubble is largely believed to have been abetted by a host of measures undertaken by the government. The central bank had loosened monetary policy, leading to falling borrowings costs stimulating investment. Similarly, several liberalizing laws had made it easier for funds to invest and for firms to offer shares to the public for the first time.

Thus, after languishing over the past few years, the stock markets in Shanghai, with 831 listed companies and Shenzhen, with 1700, took off last summer rising to dizzying heights. Shares of newly listed companies soared, sometimes thousands of percentage points within months of their initial public offering, fueling a large amount of speculative buying among a new cadre of retail investors which included tens of millions of ordinary workers, farmers, housewives and pensioners.

As Orville Shell from the Guardian reported in “Why China’s Stock Market was Always Bound to Burst”, there were several unmistakable signs that should have raised alarm bells. First of all, Chinese stocks were climbing ever higher while the Chinese economy was experiencing a slowdown. Secondly, a significant disparity in prices between “A-shares”, which can only be purchased by investors inside China, and “H-shares” stakes in the same companies available to foreign investors through the Hong Kong exchange, should have been a telltale sign that Chinese investors were bidding up prices beyond any reasonable value.

Schell reports that , “drawn by the casino-like profits to be made in the boom, more and more small investors flocked to the thousands of brokerage houses that are now proliferating in every Chinese city.” With the Shanghai and Shenzhen exchange up 135% and 150% respectively in less than a year, stocks had begun to seem like a sure thing with promises of quick profits for the millions of Chinese investors hungry for wealth. As such, compared with the 2% annual rate of return promised by traditional bank savings accounts, investing in the stock market for those able to do so,seemed like a no brainer.

Instead of focusing its efforts on regulating the speculative boom, “The government itself had become bedazzled by the seemingly invincible rise in stock prices”, according to Schell. The Chinese government took measures that further inflated the bubble. The government itself took advantage of the rising prices to sell equity stakes in dangerously debt-burdened state enterprises and clean up messy balance sheets.

What caused the market to turn?

In mid June, investors suddenly realized that stock valuations had lost touch with all fundamentals, and the bottom finally fell out. Within less than a month, the market had suffered a 32% decline. The loss of investor confidence led to a precipitous rush to sell.

The fall has been exacerbated by the amount of margin lending that had built up during the boom. Over the past few years, there had been a substantial increase in margin lending in which individual investors borrowed from a broker to buy securities. While the market was booming this allowed small time investors to put very little money down, borrow the rest to buy stocks, and then pocket outsized profits when they sold. However, the explosion of margin lending left many households highly exposed to the risk of a drop in stock prices. As prices of securities began to fall in mid June, brokers made demand for more cash or collateral (margin call) which meant that investors had to sell immediately. .

What measures have been taken?

Since mid June, nearly half of the market, or 1300 companies have suspended their shares in an attempt to stall the steep decline. Meanwhile, in desperation, the Chinese authorities hastily enacted a series of measures which they hoped would stop the decline.. They curbed the amount of new shares issued, in order to prevent any further dilution, and enlisted brokerages and fund managers to buy large quantities of shares, supported by the China Securities Finance Corporation (CSFC), China’s state backed margin finance company which has a direct line of liquidity from the central bank. On July 4, China’s top 21 securities brokerages pledged to invest at least 120 billion yuan (19 billion dollars) collectively to help stabilize the market.

Despite these measures, the Shanghai Composite index closed the month of July with a decline of 15%, the worst it has suffered since 2009. On August 10, the People Bank of China’s 2% devaluation of the yen, enacted in an attempt to respond to their recent economic slowdown, caused stocks to drop even more over the following days. On August 14, the CSRC surprised the market and the world by announcing that Beijing was going to allow market forces to play a bigger role in determining prices, marking a dramatic reversal from its previously interventionist stance.

On August 24, following the dramatic one day 8% drop which erased all gains for the year, the Chinese central bank again cut interest rates. A few days later on August 27, senior Chinese central bank officials shocked the world by telling Reuters that wide gyration of markets over the past week was caused by concerns over a possible interest rate rise by the US Central Bank rather than any measures by the Chinese government. At this date therefore, it is not clear what the Chinese government can or will do.

Will this spread into other markets?

The effect of the Chinese stock market drop is being most immediately felt by a broad decline in commodity prices around the world. Particularly, China’s problems have further pushed down the price of oil, which briefly fell to under $40 a barrel in the United States. The price of most other commodities, notably copper and aluminum have also been undermined by the possibility that lower than expected sales to China, which is the largest market for industrial commodities.

Russ Koesterich, Global Chief Investment Strategist at Blackrock noted that the roller coaster ride in China is mainly a domestic one, because, as noted above, most foreign investors hold H-Shares that did not experience the same bubble valuations and the linkage between China’s economy and its stock market isn’t particularly strong. Nonetheless, markets around the world became jittery as the Chinese bubble continued to deflate. The Chinese “Black Monday” on August 24, caused world markets to tumble in a rout that erased $3 trillion in value from stocks globally. While most markets stabilized the next day, ending fears of a free fall, the recent turmoil caused by China has led many investors to turn their focus to government officials- who have become the most prominent players in many financial markets since the 2008 crisis. In particular, the apparent eternal debate about whether the Federal Reserve in the United States will still follow through with plans to push through an interest hike has once again been revived.