China Stock Market Crash: Cause and Effects

China stock market has been hogging headlines constantly since June 13 and this time the reason is neither high economic growth nor the exceptional quarterly earnings. It is in news for all the wrong reasons. Both the Chinese stock market, Shanghai Composite stock market index and the Shenzhen Composite index have lost more than one third of their market capitalisation since it reached the all- time high on June 12, 2015.

The Shanghai Composite stock market index has plunged 32 percent after the high on June 12 and the Shenzhen Composite index has nosedived 40 percent over the same period. In less than one month, 24 trillion Chinese Yuan (about $4 trillion) have been erased from the market capitalisation of the Chinese stock market.

Causes for Chinese stock market crash

Although no specific or concrete reasons for this economic disaster have been derived yet, many causes are under speculation. These can be briefly summarised as:

Rise in Margin Buying: Margin Buying is basically investing the funds borrowed from government into stocks and equity so as to gain handsome returns. Government sets some margin ratio for investing in equity market where part of the invested amount is borrowed and part is consumers fund.

Chinese stocks surged last year but those gains didn’t reflect broader economic gains. Rather, they were a result of more and more people investing in the stock market with borrowed funds, which led to instability and volatility in Chinese stock market. Stocks progressing and going up during good economic and market conditions is normal but due to margin money investing, although when Chinese economy slowed down and posted a growth rate of 3-4%, the stock market boomed.

Investing borrowed money used to be heavily restricted in China, but the authorities have gradually loosened the regulations since 2010. Over the same period, Chinese people found increasingly creative way to evade those regulations. Although still after loosening of regulations, a 2-1 margin was required as a result of which only half of investment funds could be borrowed and the investor had to put the other half.

But as these regulations were not followed effectively borrowed money flooded into the Chinese stock market between June 2014 and June 2015 leading to stock price to soar unto 150%. As a result a bubble was created eventually and the stock market gained from 403 billion Yuan to 2.2 trillion Yuan.

Margin debt rose by tenfold last year and it doubled again the first six months of this year—undoubtedly helped to fuel the sharp increase in Chinese share prices over the past two years.

Recent Stock market crash may reflect, at least in part, an unwinding of this previous margin buying.

Negligence: According to an interview with Ms. Wu Xiao of Phoenix TV in Hong Kong on March 17, 2012, Xiao confessed that he did well in Chinese literature but poorly in math in his national university entrance exams. Rumours have it that Xiao could not comprehend what was the five-day moving average when some of his subordinates suggested that the CSRC pump funds to stabilize the SSEC at that level.

Foreign Speculations: Speculation are such that big foreign banks and institutional investors have been shorting Chinese stocks which has led to stock market crash but the Global Times, a state-run newspaper that tends to look for the evil consequences of external forces, came out to dispel the rumour by stating that “foreign capital has only a small part of the Chinese stock market” and that “large-scale short selling by foreign investors in the Chinese stock market has not appeared and is an unlikely scenario.”

Effects of Chinese Stock market crash

1) Effects on Consumer Spending:

During June 2013 Chinese households directly held about 20 percent of the market capitalisation of the Shanghai stock market. Assuming that households own a similar proportion of the Shenzhen stock market capitalisation and assuming that the ownership proportions have not changed significantly over the past two years, then households would have lost more than CNY 5 trillion (nearly $900 billion) since the market peak on June 12. If we assume that households are the ultimate owners of the shares held by institutions then their losses would approach CNY 9 trillion (about $1.4 trillion).

Losses of this magnitude cannot be ignored and they are going to affect the spending capacity of consumer in one or the other way. But despite the recent nosedive in share prices, the Shanghai Composite index is still up 8 percent year to date and the Shenzhen index remains more than 30 percent higher than its December 31, 2014 close. Unless stock market gains and losses instantly affect spending decisions by Chinese households, which seems uncertain, then the recent swoon in Chinese share prices may not have as large an effect on consumer spending as the CNY 9 trillion loss in “paper wealth” may imply. Moreover in terms of wealth investment of all the households are most in the form of bank deposits and so this stock market crash will erode the net worth of an individual by not more than 3%. So we can assume that the stock market crash will not affect the spending capacity of a Chinese to a larger extent.

2) Effects on Investment Spending: The equity market in China is relatively small and only 12% of the investment is in stocks and equity market. Although the run-up in share prices in China over the past two years would have pushed up the ratio, the larger point is that China is, and remains, an economy that is largely bank financed.

3) Other Effects:

i) The impact on US markets has been limited, and concentrated primarily on Chinese companies listed on the US exchanges. Global companies that relied on the Chinese market suffered from the crash. Stocks that they own were devalued $4 trillion. For example, French alcoholic beverage company and British luxury-goods company, Burberry, saw their shares devalued and declining demand of their imports from Chinese distributors. Second-quarter sales of American fast food company, Yum Brands, in China dropped 10 percent, resulting in revenue going under the company’s estimate. South African ore mining company, Kumbla Iron Ore, eliminated its dividends on 21 July as the 61 percent loss of profit in the first half of the year was announced.
ii) Although real impact on the global economy is limited, the crash sent a signal that the Chinese economic slowdown and instability are becoming entrenched, undermining the confidence of foreign investors. Steps Taken By Chinese Government:

Steps taken by the Chinese government

Rate Cut: On June 27, the People’s Bank of China (PBOC) stepped in to stop a sell-off in Chinese stock markets, cutting benchmark interest and deposit rates by 25 basis points each (to 4.85 percent and 2 percent, respectively) and the reserve requirement ratio (RRR) for some banks by 50 basis points.

Stocks Buying: On June 29, the Ministry of Human Resources and Social Security and the Ministry of Finance published draft regulations allowing pension funds managed by local governments to invest in stocks, funds, private equities, and other stock-related products. On July 1, the CSRC allowed investors to use homes and other real assets as collateral to borrow money to purchase stocks. On July 4, 21 brokerages set up a fund worth about $19 billion (RMB 120 billion) to buy shares.

Suspending IPO: On July 4, CSRC suspended all new initial public offerings to reduce volatility.

Banning share sale: On July 8, CSRC banned shareholders with stakes above 5 percent from selling shares for six months.

The Way Ahead

Growth in BFI spending in China may slow in coming quarters, but it is unlikely to collapse, based solely on the recent decline in Chinese share prices. Similarly, growth in Chinese consumer spending, although it may slow somewhat in coming quarters, is not likely to weaken significantly due to the swoon in the stock market. Although we look for the overall rate of real GDP growth in China to trend lower in coming quarters from the 7.0 percent year-over-year rate that was registered in Q1 2015, it is unlikely that the collapse in Chinese share prices over the past month portends a sharp downturn in the Chinese economy.

(Parth Agrawal is MBA(IB) student at New Delhi-based Indian Institute of Foreign Trade.)

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