China's Crisis Caused by Unhealthy Stock Market Growth

China’s stock market has experienced a lot of volatility in 2015, with a very disconcerting slide starting in June. The Shanghai Composite, China’s main stock market, began the year at around 3,350. It then rallied substantially to reach a high of 5,166 on June 12, a strong rise of around 54% for the year. The index then began a swift and deadly move to the downside, reaching 3,507 on July 8, 2015, a drop of 32% off the highs. The Chinese government stepped in with unprecedented market intervention to stabilize the market during the decline. This caused the market to bounce off the lows for a couple of weeks, but then the market was once again under pressure coming into the latter part of July.

Experts are pointing to grossly expanded margin lending to retail Chinese investors as one of the main reasons for the sell off. The Chinese government had been loosening restrictions on margin trading over the past few years. This initially caused the market to rally substantially as unsophisticated investors poured money into the market. However, when cracks appeared in the facade of larger companies, things began to take a turn for the worse. Margin calls for ordinary investors led to a vicious cycle of selling, resulting in the drop.

Investors with exposure to the Chinese market are rattled not only by the decline but also the intervention of the Chinese government. The question becomes whether the Chinese stock market is broken or if this is merely a temporary blip in the road. Further, to what extent are investors hesitant to invest in the stock market after the government’s heavy-handed response to quell the declines?

Growth of Margin

Much of the market volatility is attributed to the growth of margin lending. The Shanghai Composite rose to a multiyear high in early April. This was fueled by increased margin lending to retail investors. The Chinese government severely restricted the use of margin in the past, but the government began loosening regulations beginning in 2010.

The amount of margin grew from 403 billion yuan in June of 2014 to around 2.2 trillion yuan

in June of 2015. This growth occurred even though the Chinese stock market regulatory authority prohibited four of the larger brokers from extending more margin in January. Adding to the problem was the fact that retail investors came up with creative methods to get around margin restrictions, allowing for greater lending. This margin amount was double the size of margin on the NYSE, once adjusted for the market’s relative sizes. It is estimated retail investors make up around 90% of the market participants for the Shanghai Composite.

Government Intervention

The Chinese government took unprecedented steps to try and control the swift decline of the market. In late June, regulators cut interest rates by 25 basis points to create more liquidity. On July 3, the government made a $40 billion six-month loan to state-owned banks to help support the economy. On July 8, the government banned company shareholders with stakes of more than 5% from selling for six months. Shares of around 1,500 companies were suspended from trading. Those remaining stocks benefited from buying supported by the government.

Reports were released that the Chinese police were investigating malicious short selling of shares. Later in July, brokerages indicated they would continue to buy stocks to stabilize the market. It is unclear whether these measures will stabilize the market in the long run. The Shanghai Composite fell over 2% on July 29. Further, the long-term damage to the market remains to be seen. Many investors in China and abroad are likely to be hesitant to commit money to the market due to the volatility and heavy-handedness of government intervention.