Understanding the Causes of China’s Stock Market Crash in 2015

By Fanhua Zeng, Wei-Chiao Huang, and James Hueng

By Fanhua Zeng, Wei-Chiao Huang, and James Hueng

Image Attribute: Pixabay.com

Before reaching the ceiling on June 12, 2015, China’s stock market had ballooned about 150 percent in a year. The Chinese stock market crash began with the popping of the stock market bubble in mid-June (starting on June 15, 2015). A third of the value of A-shares on the Shanghai Stock Exchange was lost within one month following the event. The Bank of England gave a frightening illustration of the enormous scale of the Chinese stock market rout, stating that the $2.6 trillion wiped off the Shanghai and Shenzhen Composite indexes in the initial 22-day summer market rout is equivalent to the entire GDP of the UK in 2013, and amounts to seven and a half times the nominal value of outstanding Greek government debt. The carnage did not end in 22 days. Major (more severe) aftershocks occurred around July 27 (the Shanghai Composite Index fell by 8.5 percent, marking the largest fall since 2007) and again on August 24 “Black Monday” (8.5% fall in the Shanghai Composite Index) and August 25 “Black Tuesday” (another 7.6% fall). As of this writing, as can be seen in the following charts 1 and 2, the market seems to have calmed down with the index hovering around 2900 points (compared to 5178 peaks reached on June 12). However, this relative quietness, along with shares languishing in their lows and low trading volume and volatility, shows that the market is now left in the doldrums, and is likely to be stuck for a long time. Altogether, last summer’s herd stampede has practically erased the Chinese stock market’s gains in the first half year of 2015 completely.

Chart 1 Attribute: Shanghai composite index. Source [1] http://www.marketwatch.com/investing/index/SHCOMP/charts?CountryCode=cn.

Chart 2 Attribute: Shanghai composite index volatility and policy actions. Source: Goh, E.Y. [1] 

The Causes

The source of any stock market crash may vary over specific circumstances [2] - [5], but one general reason remains generically the same: What goes up must come down. Thus we need to understand what caused the bubble in China’s stock market to form (buying frenzy) and pop (panic selloff). Between June 2014 and June 2015, China’s Shanghai Composite index rose by 150 percent. There was a strong sign that the seemingly bull market was actually entering the bubble territory as it is not justified or consistent with the economic fundamentals. The value of many shares rose at a rate and speed that made little sense. Many companies with meager earnings (or even losses) were seeing a meteoric rise in their shares. Meanwhile, the country’s broader economy was going the other way, with economic growth slowing down significantly (the economic growth rate has fallen from double-digit figure in previous years to 7%, dubbed the “New Normal” by Xi-Li leadership.) In other words, in a healthy market, stock market booming usually signals an economic expansion. But the Chinese economic growth has been declining in the past few years and was not expected to go back to the brisk growth in the near future. Therefore, the 2014-2015 run-up was clearly a bubble without support from the real economy.

A big reason for the stock market rally was that a lot of ordinary Chinese people began investing in the stock market for the first time. More than 40 million new stock accounts were opened between June 2014 and May 2015. Unlike other major stock markets, which are dominated by professional money managers, retail investors account for around 85 percent of China’s trade. “A majority of the new investors in China’s market don’t have a high school education (6% are illiterate). There are now more retail investors in the Chinese stock market (90 million) then there are members of China’s Communist Party (88 million)”, as reported by Reuters. These inexperienced retail investors dramatically increased the volatility of the market leading to much greater fluctuations in the stock market than would otherwise be the case. This is because of they, unlike institutional investors who are professionals engaging in long-term investments on the basis of rational market analysis and projections, typically engage in short-term speculations based on hearsays, rumors, and irrational projections. As a result, they tend to exhibit herd behavior causing much greater share price fluctuations than would otherwise be the case.Worse yet, many of these novice investors were making highly leveraged purchases with borrowed money.

This practice, known as “trading on margin”, used to be prohibited in China. But then the Chinese government lifted the prohibition changing policy to strictly regulate the practice of margin trading. Over the past five years, the Chinese authorities have gradually relaxed the restrictions on margin trading. The newly relaxed 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. However, people also found a number of creative ways to evade these requirements. As a result, many people have been able to make even riskier bets than the official rules allowed.

The 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. Experts estimated that another 2 trillion yuan or so of borrowed money has flowed into the markets using vehicles designed to skirt official limits on margin trading. So, margin trading―and margin debt―skyrocketed, and a perfect storm was forming.

The surge in stock prices alarmed Chinese authorities. Earlier this year they took steps to rein in margin trading and other forms of leveraged investing. In January, they raised the minimum amount of cash needed to trade on margin. They also punished a dozen companies for failing to enforce rules on margin trades. In April the government cracked down on vehicles designed to skirt the margin trading rules. The government’s toughest measures came on Friday, June 12, when China’s securities regulator announced a new limit on the total amount of margin lending stock brokers could do, while also reiterating the curbs on illicit margin trading. Looking back, this announcement acted as the last straw and triggered the market to fall on the following Monday. When the market nose-dived, investors faced margin calls on their stocks and many were forced to sell off shares in droves, precipitating the crash further. Now the bubble has popped.

So on the surface, it looks as though the retail investors are to be blamed for their own irrational exuberance that caused the crash. But beneath the surface, the Chinese government is not without fault (if not to be faulted as the culprit, at least to be blamed for mismanagement). The crash also reflects the underlying structural problems of the economy. In the recent past years (especially since the 2008 great recession), Beginning in the early 1990s China has achieved two decades of remarkable double-digit growth. But it is increasingly clear that this export and investment-led growth is not sustainable without substantial restructuring and rebalancing of the economy. Then came the 2008 great recession, causing global demand to fall precipitously and China could no longer keep its growth going through exports. And its own citizens weren’t consuming enough to create the demand necessary to keep the growth engine revving either. The Chinese government’s answer was to mount a massive stimulation package, using monetary policy, state-owned banks, local governments, and other tools under its control to push internal investment. The result was a massive buildup in factories, highways, airports, real estate, and much more. Some of these investments were wise. Many weren’t. China has become famous for its profusion of empty stadiums, skyscrapers, and ghost cities. The result is a lot of overcapacities and many state-owned enterprises and local governments are ridden with enormous bad debt. This is part of why the Chinese government encouraged the stock market boom. As said by an analyst, “The Chinese government basically comes up with this plan. 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.”

In a sense, the stock market boom was caused by government’s strategy to solve the debt problem of zombie state-owned enterprises and the government’s (China Securities Regulatory Commission) facilitation of margin trading by relaxing the previous restrictions. This coincided with the timing when the Chinese property market went down, and people who were putting their money in property began looking elsewhere for better returns. Lots of novice investors got into the stock market because the Communist Party, in word and deed, was pushing them into a debt-fueled binge in the stock market. State media also played a prominent role in drumming up the stock market bubble in the first place. The official Xinhua News Agency published eight articles on the stock market in a space of three days in early September 2014 to solicit investors joining the historic gambling, and in March 2015, the CCP’s mouthpiece People’s Daily issued a three-article series, “A Share Volatility [Is Part of] a Slow Bull; [Index] Expected to Challenge 4000.” As the Economist puts it, “The government got all of the corporations in China that were going broke to go public. Then, they got the average Chinese citizen to invest.” and “Officials are seen to have promised the population a bull market, only to lure them into a bear trap” (quoted by James Richards in his blog posted on August 10, 2015, at Daily Reckoning.com).

About the Authors:

Fanhua Zeng, School of Economics, Zhongnan University of Economics and Law, Wuhan, China.

Wei-Chiao Huang, Department of Economics, Western Michigan University, Kalamazoo, Michigan, USA.

James Hueng,  Department of Economics, Western Michigan University, Kalamazoo, Michigan, USA.

Publication Details:

This article is an excerpt taken from a research article titled - "On Chinese Government’s Stock Market Rescue Efforts in 2015" published in  Modern Economy, 7, 411-418. DOI: 10.4236/me.2016.74045.

Copyright © 2017 by author and Scientific Research Publishing Inc. This work is licensed under the Creative Commons Attribution International License (CC BY 4.0).

References:

[1].  Goh, E.Y. (2015) China’s “Desperate” Stock Market Rescue Was Necessary. Caijin, July 25, 2015. 

[2]. Huang, W.C. and Zhu, Y.L. (2004) Are Shocks Asymmetric to Volatility of Chinese Stock Markets. Review of Pacific Basin Financial Markets and Policies, 7, No. 3. 

http://dx.doi.org/10.1142/S0219091504000159

[3]. Hueng. J.C., et al. (2014) Choosing between Value and Growth in Mutual Fund Investing. Financial Services Review, 23, 341-359.

[4]. Hueng, J.C. and Huang, P. (2009) Interest-Rate Risk Factor and Stock Returns: A Time-Varying Factor-Loadings Model. Applied Financial Economics, 19, 1813-1824. 

http://dx.doi.org/10.1080/09603100903049674

[5]. Hueng, J.C. (2006) Short-Sales Constraints and Stock Return Asymmetry: Evidence from the Chinese Stock Markets. Applied Financial Economics, 16, 707-716. 

http://dx.doi.org/10.1080/09603100500426697