Between June 2014 and June 2015, China's Shanghai Composite index rose by 150%. Chinese citizens began investing in the stock market for the first time. Bloomberg reported that 40 million new stock accounts were opened between June 2014 and May 2015. And many were buying stocks with borrowed money.
Last month, Andrew Foster, manager of Seafarer Overseas Growth and Income Fund, explained the situation to Jason Stipp, editor of Morningstar’s U.S. website. His view has reproduced below.
“Chinese households to begin with have very little exposure to equities. They've had way too much of their savings and investments in residential real estate, and equities have occupied a small part of their portfolios. So there was a natural inclination to allocate more to equities that was building within the Chinese society. However, that was fuelled in a very aggressive manner by a very pronounced availability of margin finance. In other words, households were allowed to borrow large sums of money against sometimes very questionable collateral in order to purchase shares, which is a very risky undertaking.
Especially, if the stock markets fall, it tends to mean that investors, having borrowed the money, will liquidate their shares quickly to repay those borrowings. So it makes the market very fragile and precariously balanced.
This availability of finance was spurred by the Chinese government in a certain sense, because the government was keen to see this rebalancing take place and especially to boost share prices within the country, which until the summer of 2014, about a year ago, were very depressed.
The Chinese government is very keen to clean up and sell off its large ownership within some of its state-owned enterprises. The government has very large ownership stakes in a number of major and minor companies across the country. And the government needs new capital because it has some fiscal problems that it has to deal with, and it wants to clean up its companies and sell off its stakes to the general public, to investors. I think that's the general intent of the government, but they wanted to do it at prices they deemed to be attractive. A year ago, those stock prices were so deflated that there was a policy push within the country to get people to own more shares, and this spurred financial institutions to lend more to individuals to speculate in stocks. So, a huge wall of money hit the market quickly, and this pushed the market up very rapidly in the space of a year. It is really exacerbated by the fact that the underlying stock market within China doesn't enjoy a lot of liquidity to begin with. So you suddenly have a huge wall of money hitting a stock market without a lot of liquidity to absorb that wall of money, and it pushed the market up to precarious levels in the span of the year.”
Then came the sharp selloff which Andrew Foster explains. ….
“The peak of the market appears to have been June 8, although the really pronounced selling started about July 3. It's really difficult to pinpoint the reasons for the selling pressure with certainty. I think certain financial institutions in China began to be worried about the amount of margin finance they'd extended; they began to curtail the amount that might be available. And just the sheer imposition of some restriction on margin finance was enough to send the market a bit lower and start a snowball of fear beginning to mount within China.”
After the stock market began to tumble, the authorities intervened to prevent a carnage.
The Chinese government allowed certain companies to voluntarily suspend the transaction of their shares on the stock exchange. As a result, a huge number of stocks within the domestic market within China were frozen and are unavailable for trading. That put pressure on those households and individual investors trying to exit the market as they were forced to sell those few shares that were still trading.
Then came China’s yuan devaluation, on top of a steep slowdown in Asia’s biggest economy. China has benefitted from an export-oriented growth strategy. Now it needs to transition to an economy that's powered more by domestic consumption. And that will not be easy. The Chinese method of relying on state investment and exports is losing effectiveness. Wall Street Journal reported that exports fell 8.3% year-over-year in July, factory orders are down, and construction starts fell 16.8% over the first seven months of 2015 from a year earlier, and General Motors and Volkswagen are running their plants below full capacity for the first time in China.
Robert Shapiro, a former economic adviser to Bill Clinton, who now works at U.S. consultancy Sonecon, was quoted in The Guardian saying that the “Chinese leadership have had a fundamental policy of driving growth sufficiently great to generate employment for about 10 million people a year. The main way they’ve done this is through public investment, or semi-public investment. A lot of these projects are now going bust, because there’s nobody to purchase the apartments, and there are no businesses to rent the offices.” He says the market chaos is partly a direct result of this phenomenon, as shares in construction and property firms are hit.
The impact on global markets is well summed up by an analyst from Deutsche Bank: “The Chinese have created an air of fragility around the globe”.
