China Stock Market Bubble Begins to Burst, Losing 7.4% in One Week

China Stock MarketChinese stocks sank again on Thursday, June 18. The Shanghai Stock Exchange Composite Index plunged 3.7% while the Shenzhen Stock Exchange showed an equally large loss of 3.6%. In the two mainland stock exchanges, there were a total of 134 companies whose share price tanked the 10% limit.

This has been a troubling week for the Chinese stock market. Weekly losses for the Shanghai Composite and the Shenzhen Composite were 7.4% and 7.9%, respectively.

Huge Loss for ChiNext Board and Banks

Stocks on the ChiNext board lost big time on Thursday. ChiNext is a NASDAQ-style board of the Shenzhen Stock Exchange; it comprises innovative and fast-growing companies, especially high-tech firms. The ChiNext Index dove a staggering 6.3% in one day’s trading on Thursday.

Shares of China’s banks tumbled during Thursday’s trading. Bank of Communications Co Ltd experienced a 9.6% drop in its share price, China Everbright Bank Co Ltd plunged seven percent, and China CITIC Bank Corp Ltd slipped 6.2%, to name a few.

Phenomenal Year for the Chinese Stock Market

If you invested in the Chinese stock market 12 months ago, you are likely to be smiling now. Despite this week’s loss, the stock market performance is still at astronomical levels. Over the past 12 months, the Shanghai Composite Index gained 136%, while the Shenzhen Composite Index surged 173%.

According to the World Federation of Exchanges, the Shanghai Stock Exchange had a total market capitalization of $5.9 trillion and the Shenzhen Stock Exchange sat at $4.4 trillion. Combined, the mainland Chinese stock markets have a whopping $10.3 trillion valuation; the increase in value was $6.7 trillion in 12 months. (Source: World Federation of Exchanges, Last Accessed June 18, 2015.)

Potential Bubble Draws Attention from Regulators

Such high levels could be a sign of a bubble in China’s stock market, and regulators are worried. Early in May 2015, one of the Chinese official newspapers, People’s Daily, warned the public, “Don’t forget the risks in a bull market.” The report described the stock market rally as “a surging wave of red hot enthusiasm,” and asked people to be aware of the dangers during “the blind pursuit of profit.” (Source: International Business Times, May 4, 2015.)

The climate is changing in the Chinese market. The China Securities Regulatory Commission recently announced that new rules were being set up to tighten up management of brokerage firms’ margin trading and short-selling business.

Margin debt has become a big concern for regulators. The soaring stock market over the past year brought with it $358 billion of margin debt. At this high level, margin debt would bring hard-to-control sell-off risks when situations go sour. When the market experiences downturns, traders will usually be forced to sell their shares to cover the margin calls.

Real Economy Lacks Growth

One reason economists are worried that China’s stock market might be in a huge bubble is that its real economy fails to show similar growth.

The country grew at 7.4% last year, a number envious by many western countries, but missed its 7.5% expectation. This year, many statistics are suggesting that China’s growth is slowing down.

The most recent trade balance report showed that China’s exports in May declined 2.8% year-over-year. Exports have been slacking this year, experiencing a 6.2% decline in April and a staggering 14.6% drop in March. Imports were even worse, slipping 18.1% in May and 16.2% in April. The weak imports suggest weak domestic demand and slowing consumer consumption. (Source: General Administration of Customs, June 8, 2015.)

Manufacturing has been struggling, too. The Purchasing Manager’s Index (PMI) is an indicator of the economic health of the manufacturing sector, with readings above 50 indicating an expansion. However, the readings were 49.2 for May and 48.9 in April. Note that May is the third consecutive month with readings below 50, suggesting a steady contraction in China’s manufacturing sector. (Source: HSBC/Markit, June 1, 2015.)

According to HSBC/Markit’s PMI report, manufacturing output, new orders, and employment all declined in May 2015. Part of the decline is due to weak foreign demand. New export business in manufacturing experienced the sharpest drop since June 2013.

To get China’s growth back on track, the People’s Bank of China (PBOC) lowered its one-year benchmark lending rate by 25 basis points to 5.1% on May 10. The Chinese central bank also cut the one-year deposit rate by the same amount to 2.3%. Note that this was the third interest rate cut by China’s central bank in six months.