Causes of the Chinese Stock Market Crash 2015

Post June 12, the Chinese stock markets dropped more than 30% in a month. This amounted to about $3 trillion in market capitalisation lost by listed companies in China. What’s more interesting is the fact that this sharp plunge came after a year-on-year rise of over 150% from last year.

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Why did the markets rise so much? Why did they fall so much? How does it impact China? How is China tackling this problem? And finally, how does it impact you and me, sitting outside of China? This article seeks to answer these questions, answering the Why to every What.

Stock markets are one of the indicators of the overall economic growth of a country. If the economy grows, it results in and implies that the companies would have fared well and the stock markets would have risen. It is plausible for the markets to fluctuate and even rise sharply over a single day or fall sharply to unbreathable levels; but if stock markets are an indicator, they must be in line with all the other indicators of the economy as well, which was not the case. Growth in China had slowed down to below 7%, the slowest in 25 years, while the 150% increase in stock markets happened. Clearly something was wrong and the rise in the market was not justified. It created a stock bubble waiting to be popped.

The stock markets are governed by the interaction of demand and supply. More demand,higher prices; more supply, lower prices. Over the last one year, the investments into the stock market (demand) rose by an unprecedented level. The Chinese property market went down, so people who were putting their money in property began looking elsewhere for returns. At the same time, the Chinese government was extremely eager to inject value into the market as Vox reports:

 “China has become famous for its profusion of empty stadiums, skyscrapers, and even cities. The result is a lot of overcapacity and bad debt. This is part of why the Chinese government encouraged the stock market boom. They see they have these heavily indebted companies that need to raise money to clean up their balance sheets. They realize there are these huge savings in China that can be put into the stock market. So they begin talking up the stock market and they make it easier to use margin debt. And margin debt exploded.”

This and the government’s haste in making China an export-led manufacturing hub required massive internal investment that were raked in through the stock markets. Lastly, in a drive to move from an export-led to a consumption-based economy, China wanted more money in the hands of its people so that consumption surges. (Why? Read this)

Investing borrowed money used to be heavily restricted in China, but the authorities gradually loosened the regulations and by 2014 because of the above reasons. Margin trading became extremely liberalised to attract investments. Let’s understand what margin trading is: Margin trading is the option of purchasing shares in the market using borrowed money from the stock broker. Say, Suresh wants to purchase stock worth ₹1000 (100 shares of ₹10 each). The minimum collateral requirement or the minimum amount that has to be invested by Suresh himself is 50%, set by the government. Therefore Suresh has to put in ₹500 and his stock broker the remaining ₹500 (credited to Suresh). There are two things to note here:

  1. If the stock rises to be worth ₹1200 later, he would still have to pay ₹500+interest to the stock broker and he can pocket the remaining amount. This would give Suresh a higher rate of return on his investment than if he had put in the entire amount (1000). But just like margin trading increases gains (ROI), it also magnifies losses. Essentially, margin trading is more risky than regular trading.
  2. The 50% rate of collateral must be maintained at all times. So in case the stock goes down to ₹800 (100 shares of ₹8 each), the stock broker can hold ₹400 of it from his money, but at present he holds ₹500. Therefore, the stock broker will ask the inventor to pay him the difference or sell off some of the shares and pocket the entire amount to set the ratio right. In this example that would mean him selling off say 30 shares to pocket ₹240, be left with  ₹260. 50% of the remaining stock value would be 50%*{(100-30)*8}= ₹280. Since his lent amount (260) falls within the upper limit of ₹280, he’s good. This video explains this concept: Investopedia

(You’ll see why these two points are very important later)

With the introduction of margin trading, the number of people and the amount being invested in the stock markets grew exponentially because it seemed so lucrative with less capital requirement. So borrowed money flooded into the Chinese stock market between June 2014 and June 2015, helping push stock prices up 150% (too much demand/buying). During this period, the amount of officially sanctioned margin trading in the Chinese stock market ballooned from 403 billion yuan to 2.2 trillion yuan!

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But wait a minute. Margin trading might be a new thing in China, but it had been prevalent in other parts of the world for decades. Why didn’t this market rally (sharp increase in prices) happen at other places? The reason is the composition of investors in China. 80% of the investors were retail investors, the highest anywhere ever. They were not sophisticated veterans of global finance. Quoting from Ruchir Sharma (ex-SRite), WSJ, “At the leading brokerages, 80% of margin finance has been going to retail investors, many of them new and inexperienced and two thirds of new investors lack a high school diploma. In rural villages, farmers have set up mini stock exchanges, and some say they spend more time trading than working in the fields. The signs of overtrading are hard to exaggerate. The total value of China’s stock market is still less than half that of the U.S. market, but the trading volume on many recent days has exceeded that of the rest of the world’s markets combined.” Such investors exhibit a strong sense of herd mentality and make irrational choices. Therefore looking at margin trading, everyone in China wanted to jump the bandwagon, something that wouldn’t have happened if the investors were making rational choices. This inflated prices over the year.

Realising this crazy debt-fuelled buying of stocks, the Chinese government finally sought to put curbs on margin trading. In January 2015, they raised the minimum amount of cash (collateral requirement as discussed earlier) needed to trade on margin. Further 12 brokerage companies were punished and some banned from margin trading based on inspections. It found repeated violations including improperly signing out margin contracts.(Example: The rules say that margin loan term must not exceed 6 months. This rule is intended to force investors to close out their trades after 6 months and recognise any losses, rather than using credit to keep trades open indefinitely. These companies were violating this and many other such rules).

As soon as this crackdown on margin trading began the buying of shares slowed down. Also since the minimum collateral requirement was raised, stock brokers started selling the existing shares to get to the new ratio (read point 2 from above again) This led to less buying and more selling activity that reduced prices. Now remember how losses are also magnified because of margin trading? People were losing money, they started selling their stock Expecting further price falls. Since prices fell, stock brokers further sold more shares to keep maintaining the ratio (as in the example of Suresh). This further reduced prices, which led to further margin calls being made. It became a vicious cycle. All of this led to more and more selling which kept reducing value from the market which eventually led to this collapse.

The second reason for this was that a large number of buyers in the share market had been using shadow banking system to buy their shares through what are called as ‘umbrella trusts’. Umbrella trusts allow investors in the stock markets to get lent money on a much higher rate of leverage ie the collateral requirement is much lower. Putting curbs on WMPs and shadow banking can wipe away 60% of the credit availability in the market. Understand what Shadow Banking and WMPs are here Reservoir: Shadow Banking On June 12, the government started curbing WMPs and these trusts and subsequently erased a huge source of funding for buyers in the share markets. Consequently, buying activity slowed down considerably and stock markets plunged. In essence, it can be concluded that the Chinese governance that fell prey to the lure of short-term gains that led to this crash.

Now that you know what caused it, read the aftermath of the crash to know how it effects China, India and the world at Reservoir: Understanding the Stock Market Crash of China 2015: The Aftermath. As they say, half-knowledge is worse than no knowledge, go on read the second part! 😉

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