Story Of The Week

The China Story

After a year of flying sky high, with investments pouring in the Chinese stock market like wildfire, the Chinese dragon seems to have lost its fire. While all the attention was fixed on Greece and the reaction of markets world over to the ‘NO’ vote to solve its $382 billion debt problem, the China bubble was slowly popping.  Suddenly, brought to light was the Chinese stock market crash, which saw a whopping 40% decline in just one month.

Barely a month back, on June 12, Shanghai Composite (SSEC) had closed at 5166.35 points, its highest since January 18, 2008. Yet by the end of July 3, the SSEC shed 1481.99 points, losing almost 29 percent of its recent high and over $3 trillion in value (which is incidentally almost 10 times of Greece’s annual GDP!).

Shanghai 1 Year Index

And it’s effects?

Yuan fell. Yields on Chinese government bonds spiked. And neighbouring Asian stock markets declined in response to Shanghai’s fall. The globalization of China’s economy that the world had pushed for three decades is now showing its dark underside.

The China’s economy on the whole is now under speculation. According to economists Patrick Chovanec and Derek Scissors, ‘the continuous decreasing of GDP growth targets by the government most likely understates the stagnation in China’s production and economic activity’. Add to that China’s massive debt problem, its tightening labour market and the trouble in implementing reforms under President Xi Jinping, and it paints a picture of an economy which is treading troubled waters.

So what actually happened?

Well, we know usually stock market goes up in any economy during its boom period and falls during times of recession. This is because people are optimistic about future performance of companies, which due to increase in GDP consumption will increase, resulting in increase in production of the companies and consequently profits. This makes the stocks of any company valuable and the trading increases. But the huge rise in China’s stock market that began in mid-2014 was not a result of booming Chinese economy, which was actually slowing at the time. Rather, it reflected an unprecedented increase in transactions due to ordinary Chinese people entering the market and making stock investments with borrowed money.

This practice is known as margin trading, which till a few years ago was tightly restricted in China. However, in wake of becoming a more investment driven economy, these restrictions were relaxed by the government as an effort to promote more stock investment.

Unlike other markets, where investments are mostly made by institutions, more than 80% investors in China are small retail investors. The relaxation opened the flood gates of investment opportunities for ordinary people, who entered the stock market in droves. And these Between June 2014 and May 2015 alone, 40 million plus new stock accounts were opened. Their money pushed the stock market up by 150 percent in less than a year!

By early 2015, authorities realised that perhaps stock prices were increasing faster than was required. The two practices very prevalent at the time were margin trading and short- selling. While margin trading refers to betting on stock market using borrowed money, short-selling allows investors to use borrowed shares to wager on falling stock prices. While these helped in boosting the Chinese stock markets, it made the market very volatile, increasing the investment risk and instability. Consequently, in the first half of 2015, new restrictions on both these practices were imposed. On June 12, a new limit was imposed on the total amount of margin lending stock brokers could do.

At the same time, fears which were erstwhile just rumours that Chinese stock market was driven more by momentum rather than fundamental, grew. Investors started fearing that Chinese stocks were grossly overvalued, especially since the country’s economy was not growing (Its GDP growth rate in the last year was just 7% as compared to 14% in 2007). This led to a sharp increase in sell-offs, and the stock market has been falling ever since. People who were trading with borrowed money were forced out of market because of falling prices, and the volume of trading quickly eroded.

Chinese culture, like Indian culture, is savings driven. At macro economy level, people spend more at certain times of the year, like Chinese New Year, or chase huge investments like a house. Consequently, there was a huge retailing investment in the stock market. Suddenly, due to slum in stock market, the value of these investments fell drastically. The common man suddenly felt poorer as the house worth 4 crore he was living in became worth only 2 crores. Although one may argue that he is not actually poorer, since he was not really extracting any revenue out of it, but the important implication is that when you feel poorer, you hold back, and postpone your expenses. This at the time when the government is trying to push back and increase consumption spend by encouraging people to go out and eat at in a restaurant. It’s because it needs to increase that part of the economy and make it more investment attractive, to become an investment driven economy.

Slump in the stock market causes the whole cycle to collapse, and that is worrying because when we talk about China, we talk about a very important component of the global economy. It’s a huge problem, especially for a risk averse investor. The danger for China’s leadership now is that this perception may become a self-fulfilling reality, that the perception of risk of whole Asian markets suffering on Chia’s account may cause investors to withdraw their investments, leading to greater instability in Asia.

Margin trading also poses two threats for the government:

  • Political: Over the past year, tens of millions of ordinary people invested in the stock market because of government’s encouragement. These people would undoubtedly hold government responsible if they lose their money, and this could pose a serious threat to the government’s legitimacy.
  • Financial: It may trigger a financial crisis like the one in 2008. Like ordinary Chinese investors who used stocks as collateral to borrow money and buy more stocks, Chinese companies also used their own stock as collateral for loans. Other financial institutions -trusts also made risky stock investments with borrowed funds. If stock prices fall, creditors might start to call in these loans, triggering the same kind of domino effect that did so much damage to the US economy seven years ago.

This was evident by a recent headline which announced China billionaires Jack Ma & Wang Jianlin losing $800 million in the recent stock market crash.

But China is not sitting idle. So what is it doing?

Well, for starters, a number of steps have been taken by government in the last 1 year to push back the fall:

  • Stimulus: To counteract the slowing Chinese economy, a new $40 billion plan was announced by the government to foster growth in areas which needed it.
  • More Government spending: China will be speeding up infrastructure spending by building roads and public utilities.
  • More than half the stocks stopped trading: In the last week, in an attempt to revive the market, about 2.6 trillion worth of stocks were requested not to be traded.
  • Chinese government also relaxed the rules imposed on margin trading once more.
  • China stopped any new listing or release of IPOs over the weekend.
  • Big shareholders can’t sell for 6 months:From 8th July, controlling shareholders and board members are prohibited from reducing share holdings via the secondary market for six months.
  • Devaluing Yuan: China’s currency fell heavily against the dollar in July. There’s a speculation that it will depreciate even further. A weaker yuan makes Chinese exports cheaper, and so should help jumpstart growth.

 At the same time, it’s worth remembering that China’s stock market remains a relatively smaller part of the overall economy, accounting for less than 1.5% of banking assets and 15% of household wealth. So it may not have a really big effect on the Chinese economy. And so some maintain the view that this is just another hiccup in the China’s spectacular growth story, and the government, with its many measures, will fix things like it has always done. All that is needed is a little faith.

Nonetheless, wiping out over one-third of the value of those holdings is a huge blow to confidence in the economy.

Shanghai’s stock market may stabilize, and the South China Sea squabbles might recede for a time. Regardless, 2015 will be seen as the year that the world hit peak China. The question now is whether this stock market crash seriously affects Chinese economy, and if yes, how Asia’s future will be shaped by a falling, and not a rising China.

References:

1) The Business Insider

http://www.businessinsider.in/Goldman-Sachs-thinks-everyones-wrong-on-Chinas-fast-and-furious-stock-market-collapse/articleshow/48053011.cms

2) The Guardian

http://www.theguardian.com/business/2015/jul/08/china-stock-market-crisis-explained

3) Forbes

http://www.forbes.com/sites/michaelzakkour/2015/07/09/china-stock-market-crash-dont-panic-yet/

4) Business Insider

http://www.businessinsider.in/Everyone-freaking-out-about-Chinas-stock-market-crash-is-missing-one-thing/articleshow/47976738.cms

5) The Wall Street Journal: The Risks of a Falling China

http://www.wsj.com/articles/the-risks-of-a-falling-china-1436806217

Advertisements

Categories: Story Of The Week

2 replies »

  1. Good article.. very informative.. especially liked the link to the US housing bubble.
    Just to add the on of the biggest stimulus by the Chinese Govt. has been the reduction in the reserve ratio and quarter percent rate cut (this is a record low) fourth since November. .

    Anyway, great work appreciate it.

  2. Crash in stock market of also erupted another chain in world economy. Generally Gold is considered as the safest option in wake of economic crisis (Euro crisis and china stock crash),but gold market itself is trending in red over last couple of months.One of the biggest reason(along with stronger dollar) is the Chinese consumers selling gold in wake of losses they made in stock market from mainly the borrowed money .