Economic Collapse: This Could Ignite a Chinese Stock Market Crash

Chinese economic collapseThis Could Spark a “1929-Like” Stock Market Crash

For most financial analysts, hearing the words “China” and “economy” triggers a vision of power and momentous growth. However, the economy of China is far more susceptible than they assume. In truth, the value of the renminbi could crater if the Chinese economy falters again, sparking a Chinese economic collapse and global stock market crash in 2016.

The stock market crash in China this past summer was alarmingly clear in the signal it should have sent to capital markets-that the pretense at liberalism is failing. China may have convinced the International Monetary Fund (IMF) to adopt the renminbi as a reserve currency, but that does not make the transition complete.

For the renminbi to truly become a reserve currency, it must gain one more thing: the faith of markets. Right now, that doesn’t seem like much of an issue. China played a careful hand by making the renminbi more freely usable and issuing yuan-denominated debt. China did it all so that the IMF would elevate the renminbi.

In a way, that made the current situation all the more dangerous. Technically, the renminbi is a reserve currency of the world now, but it doesn’t have a history of holding up without currency manipulation. I mean, the Chinese government had to literally list two values for the renminbi: the onshore yuan and the offshore yuan.

That being said, a second stock market crash is coming. This one looks a lot like the 1929 stock market crash that utterly obliterated Wall Street, but with the Shanghai Stock Exchange as the new backdrop. Here’s how and why it’ll go down.

China Economy Set to Collapse in 2016

The renminbi doesn’t have the collective goodwill of the market, yet it just became entrenched in global affairs. Don’t get me wrong, the inclusion of the yuan in the IMF’s basket of reserve currencies is a high honor. China should be proud for maneuvering the renminbi into such an important status. (Source: “Here’s Why China’s Currency Will Be Included in the IMF’s Basket,” Fortune, November 16, 2015.)

That doesn’t mean it makes China, or the global economy, any safer. In fact, the transcended yuan is in a position to cause greater harm than it did during the summer, specifically because it is more deeply entrenched in the global currency system.

To understand what I’m talking about, you need to know why China’s stock market collapsed in June of this year. The nearly 30% selloff happened at the end of a one-year, 150% gain in the Shanghai Stock Exchange.

What caused the bull market, you ask? Well, in June 2014, Chinese financial regulators injected some adrenaline into the economy by allowing leverage on the stock market. Leverage just means borrowing money to amplify your investment. A little bit is useful, but a lot is harmful.

Too much leverage leads to risky behavior, which leads to the kind of financial speculation that caused the 1929 stock market crash and the 2008 financial crisis. Over the course of one year, it led Chinese investors to turn the Shanghai Stock Exchange into a casino that Wall Street bankers would be proud of.

The Bigger the Renminbi, the Harder the Fall

The Shanghai Stock Exchange crashed this summer because Chinese regulators got worried about the casino-like behavior. China tried to rein in leverage and failed. Markets reacted to a lack of leverage like drug addicts in withdrawal.

Needless to say, it wasn’t pretty. Slowly but surely, things appeared to get better after the Chinese financial regulators recanted. Markets gave them a little breathing room, but then proof emerged that China’s economy was slowing.

Exports were falling and China was forced to devalue the yuan, something they were trying to avoid while the IMF was mulling over the reserve currency status. But the IMF upgraded the renminbi anyway.

Now the financial regulators are tightening leverage ratios again, thinking that markets will have faith in China’s economy. (Source: “China Stocks Rise on Suspected State Buying After Margin Curbs,” Bloomberg, November 15, 2015.)

I’m worried the Shanghai Stock Exchange will get crushed again. Too much leverage brought down the world economy in the 1929 stock market crash and the 2008 financial crisis. It’s almost certainly going to happen again in China.

If enough time has passed before the next stock market crash, then perhaps the renminbi can survive it. Maybe banks and central banks will have hoarded enough yuan to prevent the ensuing chaos, but I doubt it.

My guess is that the crash will come sooner than later. Since the Shanghai Stock Exchange will be ground zero, the renminbi will surely feel the worst of it.

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