China’s stock market crashed 30% in the last months, and analysts are unsure whether this selloff is a temporary setback or if it spells doom for China’s economy. What the Shanghai Composite Index lost in market capitalisation over the last month is equal to 15 times Greece’s gross domestic product (GDP). (Source: Vox, July 8, 2015.)
Despite the massive selloff, China’s stock market is still up more than 85% over the last year. The market went on an epic tear from June 2014 to June 2015. Oddly enough, economic growth was lackluster during that period. So what inspired the rally?
In a word, leverage.
Can We Really Trust the Chinese Stock Market?
Until mid-2014, China had long prohibited traders from borrowing money to invest in stocks, a measure designed to curb speculation. But when the government amended those rules to allow 2-1 margin calls, it meant that investors could double their bets.
The result was a five-fold increase in the amount of margin trading, from 403 billion yuan to 2.3 trillion. During the year-long climb, Chinese regulators made several attempts to rein in the use of leverage. In January, they stopped brokers from lending to investors with less than 500,000 yuan in assets. (Source: Bloomberg, January 18, 2015.)
Investors were also able to access leverage using shadow financing. Banks would set up financial instruments known as ‘umbrella trusts’ to group a bunch of investments. The products were internally segmented into tranches that ranged from low to high risk. Banks then offered the lower risk tranches to private investors as wealth management products, or WMPs. (Source: Bloomberg, April 17, 2015.)
However, banks would buy the higher risk tranches themselves and designate a fixed return. All the residual earnings would go to private investors, effectively multiplying their profits. This became a standard way of evading the 2-1 margin cap.
On June 12th, the Chinese government decided it was time to fully apply the brakes. They imposed a hard cap on how much credit stock brokers could lend to investors. And I don’t mean on just one type of investor, the cap applies to the total amount of margin trading.
Anyone wanting to leverage up their investment was out of luck. Regulators also pushed banks to close off backchannel financing through WMPs. Within days of the announcement, liquidity evaporated and the markets took a nosedive. (Source: Reuters, June 12, 2015.)
Chart Courtesy of stockcharts.com
As the direction of the market flipped, so too did the government’s policy. Worried about how fast investors were leaving the market, China decided that they would rather have a credit-financed boom than a stock market crash.
They reversed their earlier cap on individual margin trading accounts and started printing money to help prop up the market. Sound familiar?
China’s experience in recent years is strikingly similar to America at the dawn of the 20th century. Industrialization and urbanization were spreading rapidly, money poured into the stock market, people got rich—and then those markets crashed. Many of these novice investors who trusted their life savings to financial markets were poor and uneducated. They were convinced not to miss out on the promise of a booming stock market, and now they have suffered terrible losses.