The Chinese Stock Market Meltdown

Source: http://a.abcnews.com/images/Business/gty_china_stock_3_kb_150708_16x9_992.jpg

Hi folks. We’re back after one long summer break. I did a lot of traveling and enjoyed tons of unexpected experience along the way. After the trip ended, I was so bored out of mind that I had to find some stuffs to do to keep myself busy. My overwhelmed free time makes me greatly miss school and my busy schedule. A lot of things have happened to me in the past few months and so have the world. Today’s topic will be about the recent calamity of the Chinese stock market. We’ll start off by giving some background stories that led to the stock market meltdown. In the next article, we’ll further discuss what the Chinese government have done so far to calm the market and restore investors’ confidence.

In the previous decade China has relished double digit growth thanks to its rise in productivity and overwhelming exports to other countries. One imminent thing is that the fun party can never go on forever. If the Chinese economy are to grow at a 10 percent rate every year, its GDP will double in every 7 years. If the trend continues, China will take over the world, literally. It comes to one prophecy: China’s economic growth will slow down. In 2014 China economy grew by just well over 7 percent which is still relatively higher than the growth of western countries. Despite the disappointing data, China is still one of the faster growing economy in the world. The latest data also showed that Chinese import and export dropped and key indicators such as factory outputs and real estate market also faltered.

To spur growth, last year the People’s Bank of China (PBOC) eased credit by lowering the key interest rate, hoping that commercial banks will channel the attractively low-interest fund to companies to boost investments, outputs, thus creating more employment opportunities. Conversely, a huge part of the fund was channeled to brokerage firms which in turn lent the money to investors to increase their stock purchase which is known as “margin trading.” (Wall Street Journal) Simply put, margin trading enables investors with a margin account, who lack sufficient fund, to borrow money from a broker to buy more stocks.This is also known as leverage in financial terms. To quote the legendary investor Warren Buffett, “Leverage is the only way a smart guy can go broke.” Debt financing, if used effectively, can reap huge return, but it also increases the risk of bankruptcy in the time when cash flow is short. The Wall Street Journal (WSJ) reported that the debt of margin trading has risen to about 2 trillion yuan ($323 billion) in early June, an almost five-fold increase from the previous year. 

As a result of the loose credit and margin trading, the Shanghai Composite Index in June 2015 has risen by almost 150 percent since 2014 and peaked on June 12. The Shenzhen index has also increased about 180 percent in just a year. (Bloomberg data) Such dramatic increase in stock price is unheard of and unsustainable.The number is also amazingly hard to believe given the already immense size of the Chinese stock market capitalization (market value). More importantly, the bull market with dramatic stock price appreciation happened at a time when key economic indicators signal big problems -  the economy is slowing down, factory’s output decreases, import and export drops and the property bubble bursts. In Finance the term “price” and “value” are two different things. An increase in stock price does not translate into an increase in stock value. Stock value depends on many measures including current and projected earnings, future cash flow, market share, sale volume and so on. Stock price is what you pay in order to get its value. Sometimes the price represents the true value and some other time it does not which strongly depends on the demand and supply in the market. In the same way, Chinese stock value didn’t increase 150 percent in just a year which only means one thing: the stock is overvalued.

Source: WSJ

Sensing the danger of margin trading in the week of June 15, the PBOC began to tighten its credit to commercial banks with the hope of curbing the excessive funding to margin financing to purchase stock. The PBOC’s action sent fear to investors which followed by a huge stock selloff in the market, plunging the Shanghai index and Shenzhen index. I remember an analogy from one of my professor about the 2007 financial crisis. He talked about a classic dancing chair game of how the banks were dancing along with the upbeat music because everyone was dancing. When the music suddenly stopped, everyone with fear tried to find his own chair to sit, while some people who couldn’t find their own chairs are the losers. The comparison between the Chinese market and my professor’s story is that now the music has stopped, investors in China want their money out of the market because they come to term with the reality that their stocks are overpriced. In one trading day in July, the Shanghai index plunged almost 8 percent in just a single day. So far the Shanghai Composite Index has fallen almost 30 percent from its peak on June 12. Almost 4 trillion dollars of market capitalization has been lost. (CNBC)

An op-ed in WSJ gave a brilliant description of why the Chinese market is in a bubble. He pointed out to four signs: prices do not reflect the economic fundamentals, massive debt financing to buy stock, excessive volume of daily trading by retail investors, and exorbitant valuation. 

Next time we’ll continue our discussion and talk about what the Chinese government have done to calm the market and restore investors’ confidence. This market turmoil is the toughest test yet for the new Xi Jinping's administration and the credibility of this new administration lies on how it handles this tough situation. We’ll be surprised that some of its interventions with good intentions may actually backfire, shatter the confidence and drive people further away from the market.