China’s stock market crash, explained

             Investors talk in front of a board displaying share prices at a security firm in Shanghai on July 1, 2015.STR/AFP/Getty Images

China’s stock market has been plunging over the last month and the Chinese government is panicking. Over the last week it has employed a number of extraordinary measures to try to halt the market’s slide, to little effect. On Wednesday, the benchmark Shanghai Composite index fell another 5.9 percent, bringing the market’s total losses to 32 percent in less than a month.

The question is whether the plunge is just an ordinary correction after a year of big gains, or if it’s the first sign of deeper problems in the Chinese economy. 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. That has created instability and a danger that many investors will suffer outsized losses as the market falls.

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 ways to evade these rules. The last month’s stock market declines follow efforts by Chinese authorities to rein in this kind of speculative investment. But in the last week the government reversed course and began trying to boost stock prices again.

China’s current predicament bears some resemblance to the situation in the United States in 2007. Risky, poorly regulated financial investments have proliferated in China, creating the danger of a meltdown that spreads beyond the stock market to the broader Chinese economy. Yet China’s stock market isn’t as big, relative to the Chinese economy, as in developed countries, so the panic might not spread to the economy as a whole.

Investors used borrowed funds to push up stock prices

The Shanghai Composite index fell 5.9 percent on Tuesday to 3,507. That’s down 32 percent from the June 12 high of 5,166. Still, the Shanghai Composite index is 70 percent above its level a year ago, when China’s most recent stock market boom began.

The latest boom in China’s stock market is different from one that came before it. The earlier boom from 2005 to 2007 coincided with rapid growth of the Chinese economy; when the Chinese economy slowed in 2008, the stock market plunged along with it:

(MarketWatch)

It’s not surprising to see stocks go up in good economic times and down during economic downturns. But that’s not what happened in the latest boom. The stock market rise that began in mid-2014 coincided with economic growth that was slowing.

A big reason for the stock market rally was that a lot more people started buying stocks with borrowed money. This practice, known as “trading on margin,” used to be strictly regulated by the Chinese government. But as the Financial Times explains, Chinese authorities have gradually relaxed these requirements over the last five years.

The new rules still included an important safeguard, though: a 2-to-1 margin requirement said that only half of invested funds could be borrowed. The investor needed to put up the rest of the funds herself. There were also restrictions on which stocks you could buy and how long the money could be borrowed — rules designed to prevent speculative mania from getting out of hand.

People also found a number of creative ways (detailed in a helpful May report from Credit Suisse) to evade these requirements. As a result, many people have been able to make even riskier bets than the official rules allow.

So borrowed money flooded into the Chinese stock market between June 2014 and June 2015, helping to push stock prices up 150 percent. 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. And that figure doesn’t take into account the vast sums invested through backdoor methods.

Why China today is like America in 2007

(Zhang Peng/LightRocket via Getty Images)

This practice of making investments with borrowed funds is known as leverage, and it was at the core of the 2008 financial crisis in the United States. For example, large banks made highly leveraged bets on subprime mortgages based on overly optimistic real estate projections. When property values started to fall, the banks with the most leverage — and the least of their own capital at stake — lost money the fastest.

People are also making highly leveraged investments in China, but Yan Liang, an economist at Willamette University, points out an important difference: in China the risky assets are more often sold to individuals rather than other financial institutions.

Chinese banks offer wealth management products (WMPs) that promise the security of a savings account but with higher returns. Some WMPs function like US money market funds, offering modestly higher returns by investing cash in safe assets like high-quality corporate and government bonds. But in other cases, banks invest WMP funds in ways that are a lot riskier than a conventional savings account.

For example, organizations called trusts buy up bundles of assets and then re-package them into “tranches” with varying degrees of risk. The lower-risk tranches are sold to WMP investors, while the higher-risk tranches are sold to others with a bigger appetite for risk. These financial vehicles sound eerily similar to the collateralized debt obligations that contributed to the US financial crisis.

The people who buy the high-risk tranches are effectively making highly leveraged investments. The people who buy the low-risk tranches are effectively supplying the money to enable these risky bets. But this arrangement isn’t technically margin trading, so traders are able to achieve leverage much higher than 2 to 1.

Despite these risks, most of the ordinary investors who buy WMPs believe they’re making a safe investment. “About 30 percent of WMPs guarantee return of principal,” Liang says. “70 percent are not guaranteed. But a lot of people believe they’re safe.”

This kind of investment strategy works great as long as stock prices are going up. But once prices start to fall, people who bought the high-risk tranches can quickly get wiped out. And depending on how far the market falls, it could also lead to losses for people who invested in these allegedly low-risk financial products — or for banks that guarantee their customers’ investments.

In the US, the risky investments were largely made by large financial institutions, which then became insolvent when the housing boom ended and required a bailout. In contrast, most of the investments in China are made by individual investors who will absorb most of the costs if their bets go bad.

That might be good news from a macroeconomic perspective, because it means the crash is less likely to destroy overleveraged financial institutions. But having millions of middle-class Chinese people lose their savings could be politically dangerous to China’s ruling party.

But it also suggests another parallel that could be even more alarming for Chinese policymakers: America in 1929. Jeremy Warner points out that China today, like America 90 years ago, is rapidly urbanizing, with a burgeoning middle class. In the 1920s, middle-class Americans discovered margin trading, propelling the stock market to dizzying heights. Then the bubble popped, producing the Great Depression.

Chinese regulators tried to rein in leveraged stock investments

Guo Shuqing, Chairman of China’s Securities Regulatory Commission, in 2012(ChinaFotoPress/ChinaFotoPress via Getty Images)

The surge in stock prices alarmed Chinese authorities, and so earlier this year they took steps to rein in margin trading and other forms of leveraged investing. In January, theyraised the minimum amount of cash needed to trade on margin, once again restricting the practice to wealthier investors. They also punished a dozen companies for failing to enforce rules on margin trades.

In April, regulators began cracking down on the use of WMPs to fund stock market investments. This included a ban on brokers using a financial vehicle called an umbrella trust to help their customers evade limits on margin trading.

The government’s toughest measures came on June 12, when China’s securities regulatorannounced a new limit on the total amount of margin lending stock brokers could do, while also reiterating the ban on illicit margin trading through mechanisms like umbrella trusts.

Chinese stocks have been falling ever since that June 12 announcement.

Now the government is panicking and trying to stop stock price declines

A stock investor reacts in front of a screen showing stock market movements in a brokerage house in Shanghai on July 6, 2015 (JOHANNES EISELE/AFP/Getty Images)

These efforts to slow China’s stock market boom seem to be working too well for Chinese officials’ tastes. Now that stock prices are plummeted, the government is trying to prop them back up.

Last Thursday, China’s securities regulator announced it would once again reduce the amount of money required to open a margin-trading account (remember, they lowered this limit a couple of years ago, then raised it in January).

On Saturday, 21 major Chinese brokerages made a coordinated announcement, pledging to purchase $120 billion yuan worth of Chinese stocks to help stabilize the market. Chinese brokers vowed to keep buying stocks until the Shanghai index had risen to 4500. Also, 28 privately-held companies cancelled plans to hold initial public offerings that could have drained capital away from companies that were already publicly traded. It’s widely suspected that these moves were made at the behest of the Chinese government.

On Sunday, China’s central bank also announced it would inject cash into the China Securities Finance Corp, a state-owned company that finances margin trading. In other words, the Chinese government is printing money to finance leveraged stock investment. On Monday, the Chinese financial magazine Caijing reported that the government had ordered the nation’s social security fund not to sell any stock in Chinese companies.

On Wednesday, the government told state-owned companies and executives to buy stocks. It also authorized insurance companies to buy more equities and offered more credit to help people buy stocks.

But the market has shrugged off these interventions. The Shanghai Composite lost 1.3 percent on Tuesday and an additional 5.9 percent on Wednesday.

Why people are freaking out about the stock market crash

A financial crisis could shake public confidence in Chinese president Xi Jinping. (Sasha Mordovets/Getty Images)

Under ordinary circumstances, a falling stock market is no big deal. Stocks are supposed to be risky investments, and the market is still way up from its level a year ago. But there are a couple of reasons the Chinese government may be especially concerned about recent price declines.

One is how widespread margin trading has become in China. A couple of years ago, the Chinese government relaxed a rule that limited margin trading to wealthy people. Liang says that 20 million people opened stock market accounts this spring, because “everybody wants to jump on the bandwagon to gamble on the stock market.” Many opened margin trading accounts and making leveraged investments.

The borrowing magnified their gains as the market rose. But once the stock market started to fall, the leverage magnified their losses too. Someone who was unlucky enough to buy stock at the June 12 peak has lost 32 percent of his investment. But someone who bought on June 12 with a 2-to-1 margin has lost 64 percent of his investment. If the stock market falls by another 26 percent, someone who bought on margin at the peak will be totally wiped out.

In many cases, the risky investments are being made by ordinary Chinese people who use their savings — and in some cases mortgage their homes — to invest in stocks. These novice investors, many of whom have limited education and financial savy, may be surprised and angry if their savings get wiped out.

So this stock market crash — unlike the one that began in 2008 — could create a broad grassroots backlash against the authorities. And while China isn’t a democracy, the government is still sensitive to public opinion, knowing that social unrest could lead to a revolution or coup.

Even worse, the same dodgy financial products that have driven stock market volatility have also been used to make risky bets in other sectors of the economy. Some WMPs have invested money in leveraged stock market investments, but others have poured money into speculative real estate projects or business ventures. In an economic downturn, these investments could fail to pan out as well, causing even more Chinese investors to take unexpected losses.

 

[“source – vox.com”]