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Reasons for China’s Stock Market Crash & its Repercussions

Posted in Finance Articles, Total Reads: 2545 , Published on July 20, 2015

The news spreading all around across the world, which the readers of this article might also be aware of, is Greece crisis. But, beneath this huge crisis, lies another cause of worry, which may have not received the due attention- CHINA Stock Market Crash. The amount wiped out from Chinese stocks ($3 trillion) has been estimated at around 10 times of Greece’s GDP and the future looks bearish, though the index levels are still 80% up in comparison with last year. Hence the questions remain, whether the Chinese market is really down or was it too overweight earlier and if this crisis can lead to contagion effect globally.

(image: https://www.flickr.com/photos/joshdubya/)

How all of this started?

Stock markets are one of the good indicators to reflect the health of an economy. Now, a point to ponder is growth in China had come down to 7%, which was slowest in 25 years and the stock market surged more than 150% for the similar time period. So, definitely a problem exists in the working of all this. Here, root cause of the issue points to the huge role that individual investors (so called retail investors) play in the stock markets of China. They had continuously inflated the stock market bubble by investing in stocks, exceeding economic growth rate and profitability of companies in which they were funding. Retail investors in China, unlike other stock markets, comprises of more than 80% of total investors and so the market booms up with herd mentality (Two-third of these new investors even lack a diploma). With more number of small investors coming, sentiment & easy availability of cash plays a huge role in rallying the market. In recent times, Chinese property market was not providing the expected returns and hence the investors turned their eye towards the stock market. Government of China also made the environment conducive for this funding as they saw this as an opportunity for companies to clean up the high debt on their balance sheets through raising more equity. The concepts here to first understand are leveraged investing and margin trading. Leveraged Investing means use of financial instruments or borrowed capital to increase the potential returns on an investment. Margin trading is buying the stocks without having the entire money, which potentially increases the chances of positive and NEGATIVE returns drastically. Margin trading has been happening in various economies since many years, but as China has retail investors in huge volume, lot of money from brokerages started pouring into individuals accounts, through which people got massive money to invest in. One more reasons exists for this crisis- Shadow banking system. Shadow banking system is a system of intermediaries that are similar to banks. The advantage investor gets is less collateral requirement, but these institutions charge high rate of interest. In the greed of huge returns, investors get attracted to borrow money and the outcome of all this we see now is that one-third market cap of China’s stock market vanished.

Crackdown (Really?) by Chinese authorities!

The first act of Chinese officials which kind of boomeranged was easing of monetary policy through cutting of interest rates to propel up the inflation. But, this equipped people with more funds and then increased investment. Government cracked down on the margin trading and shadow banks, but this lead to increased sell-off in the market, triggering the stock crash further. China intervened more in the market, but all turned as drastic moves. Initial Public Offerings (IPOs) were suspended, short-selling was capped, and pension funds were forced to buy more stocks. All this was done to drive up the prices in market, but these actions were seen as a nearing economic collapse, which again triggered the selling and further tanking of prices.

But, do the world need to worry?

China is the second biggest market as per the market cap and it accounts for 16% of global economy in terms of purchasing power parity. These numbers show that the impact of Chinese crisis can be significant across the world. One of the unique aspect of markets in China is low presence of Foreign Institutional Investors. They account for less than 1% in the equity market in the country and hence due to the limited exposure of global investors, China’s stock market has been falling in isolation. But, this is just a short term perspective. Looking from a long term view, China is a major consumption centre. Many of the top U.S. stocks derive as much as 8% of their revenues from Asian countries, among which China is the leader. As the Chinese population gets hit, the consumption may go down gradually and the same trend could be reflected in the U.S. markets in coming future. Prices of few commodities are already getting impacted. Also, many investors will now take out their money from China & other related economies and they may invest more in U.S., thus appreciating the dollar. Strengthening of currency is good, but exports take a hit. This will impact top line of the companies and once the slow down takes on developed economies, many economies will feel the pinch.

So, should China fear?

The answer to this question is yes, but things can be improved through cautious actions. Among the financial assets of Chinese households, around 15% in only invested. So, the crashing prices may hurt less but then consumption also remains low. Debt granted for stock markets by the banks forms only 1.5% of their total assets and so their exposure is also low. But as the booming market gave thumbs up to the new government, vice-versa also holds true. So, the regulatory actions may reflect fears of panic in economy which might portray a weaker China, and this is definitely not a good sign for the world’s second largest economy.

The article has been authored by Gaurav Maheshwari, K J Somaiya Institute of Management Studies & Research (SIMSR).

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