China’s Stock Market Crash

August 24, 2015
Editor(s): Wen Lin Ong
Writer(s): Hannah Too, Erin Shen, Muni Tam

The booming performance of China’s stock market was put to an abrupt end due to risky investor practices and the nation’s declining economic growth. To mitigate the repercussions of the crash, the Chinese government not only reduced interest rates, halted sell-offs and IPOs, but also announced injections into the domestic market. In addition, the People’s Bank of China devalued the yuan to increase China’s competitiveness globally in order to open up their economy.

What happened?

For over 12 months, China’s stock market had been thriving, soaring as much as 150 percent. Yet, on the 29th of June, the stock market abruptly crashed. For a nation that is now so used to economic growth, this sudden crash proved to be a shock – the Shanghai Stock Exchange (SSE) Composite Index, one of the two main stock market indices in China, lost a third of its value over a course of three weeks starting mid-June. The bursting of the stock market bubble has no doubt provoked panic amongst investors.

What caused the stock market crash?

In the year leading up to China’s stock market crash, enthusiastic investors engaged in margin trading – a high-risk practice involving the use of borrowed funds to purchase stocks. The significant surge in margin trading, as seen in Figure 1, helped to stimulate the rise of the SSE Composite Index. Moreover, the opening of four million new trading accounts by brokers to meet rising demand introduced a large and fresh class of amateur investors. Encouraged by the state-run media and the easy access to margin financing, inexperienced retail investors – think your everyday housewife, college student, or taxi driver – flocked to the stock market in droves to try their luck. However, the issue with margin trading is that both gains and losses are amplified. Highly leveraged investors who are unable to meet margin calls would be forced to unwind their holdings to ensure quick repayment of large amounts of debt, propelling the stock market into further free-fall. The current situation in China, with respect to margin trading, draws some parallels to the U.S. subprime mortgage crisis that occurred between 2007 and 2009; low to middle income earners, who were realistically incapable of servicing their mortgage loans, were still given access to such loans.

China’s declining economic growth was another instigating factor of the stock market plunge. Prior to the crash, the stock market rally did not reflect the economic reality in China – the economy was facing downwards pressure, evident in Figure 3. The People’s Bank of China (PBOC), China’s central bank, began a series of interest rate cuts, as seen in Figure 2, in an attempt to revive the flagging economy. The continual interest rate cuts, which reduced the cost of borrowing, culminated in the SSE Composite Index skyrocketing in a mere year. In accordance with the boom-and-bust cycle, the stock market eventually reached its peak, falling dramatically when it was no longer sustainable.

What was the government’s response?

Retail investors, who consist of about 80 percent of China’s stock market, were forced to bear the brunt as their shares lost value. In hope of restoring investor confidence, the Chinese government went to extraordinary lengths to prevent the market from plunging further. In the first of a series of stimulus measures, the PBOC reduced interest rates by 25 basis points to a record low level, injecting a large amount of money to stabilise the volatile stock market. Pension funds also pledged to invest heavily in stocks to keep the stock market from further decline. Margin financing requirements were relaxed, allowing investors to use their homes and other real assets as collateral to encourage them re-enter the market.

Furthermore, the Chinese government enacted regulatory policies, such as the suspension of initial public offerings, with the aim of freeing up more money in the secondary market to slow the stock market decline. The concern, however, is that by removing access to funding, the government could potentially hinder the expansionary plans of Chinese corporations. In light of the broader picture, while these regulatory policies could have a negative impact on China’s slowing economy, such actions may in fact be necessary to halt the ongoing stock market collapse.

Most recently, the PBOC devalued the Chinese yuan on the 11th of August to increase the competitiveness of China’s exports. By strengthening the position of export heavy industries, the Chinese government is aiming to increase the fundamental value of many corporations which underpin Chinese shares and hence, boosting investor confidence. Whilst the International Monetary Fund (IMF) has welcomed the move, there are questions as to whether the Chinese government’s interventionist approach could potentially disqualify China from entering the Special Drawing Rights basket. The IMF will decide by the end of this year whether the yuan will be allowed to become a reserve currency. The Chinese government’s quest to gain more economic power would undoubtedly require the yuan of this status. Of course, to be internationally recognised, the yuan would also need to be freely tradable. This is a perfect example of the Chinese government’s conflicting desire to maintain control, yet liberalise the economy.

What does this mean for investors?

The far more disconcerting issue is China’s property bubble. Even as of late, a mere ten percent of Chinese retail investor funds are in equities. Alarmingly, and contrastingly, 23 percent of Chinese GDP is in real estate, which according to Credit Suisse is a “clear cut” bubble. The real estate market is, nevertheless, stabilising after the recent fall. Should the stock market continue its downturn, fleeing investors may further inflate the real estate bubble. There is hope that careful government management will steer the economy away from this bubble.

Investors in Australia may be sceptical about their future prospects, as China is Australia’s biggest trading partner, accounting for nearly 30 percent of Australian exports. However, it is relieving to note that this figure is only six percent of Australia’s GDP. To put this in perspective, exports to China account for 22 percent of Taiwan’s GDP. Notwithstanding the other unsolved asset bubble within China – property – perhaps the magnitude of the Australian export exposure is worrisome; the overall Australian economy remains relatively safe.

It is evident that China’s stock market plunge was caused by a multitude of factors in the economy, which in turn, had several negative implications on investors and the Chinese government. However, the Chinese government did take actions to prevent the market from plunging further and to increase investment confidence by cutting the interest rate and devaluing the Yuan. Although the Chinese stock market is still down as of today, measures made by the Chinese government should continue to be put into place until the stock market has adjusted back to its original state, increasing economic growth.

Author: Hannah Too, Harindu Kulatunge, Erin Shen, Muni Tam
Editor: Wen Lin Ong

The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.

Meet our authors:

Wen Lin Ong

Bachelor of Commerce student majoring in Accounting and Finance. Inclined towards topics that explore the intersection between current affairs, technology and the business world.

Hannah Too

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Erin Shen
Muni Tam

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