The Chinese stock market has always been a curious one for investors. It is mainly retail-dominated, making it a dangerous ground even for institutional smart money. Nonetheless, it has continually performed incredibly well since the early 1990s as China took its place on the elite table of global economic giants. The strong performance was extended into the new millennium, with the bubble peaking in June 2015. The resulting burst saw Chinese stocks lose over 30% of their values within 3 weeks, with the slump continuing into early 2016. The markets would later recover, but it was not until late 2020 that it came close to the pre-crash highs of June 2015.
The Background
The re-establishment of the Shanghai Stock Exchange coincided with the launching of the Shenzhen Security Exchange in the early 1990s, and by the turn of the millennium, there were over 1000 companies listed on the two exchanges. The growth of the Chinese economy not only encouraged more firms to continue listing in the local stock market but also inspired investments from both retail and institutional investors. The Chinese equity market continued its impressive growth until the 2008 global financial recession threatened to trigger a market correction. But the government stepped in!
The Chinese government rolled out an incredible stimulus package designed to fund ambitious infrastructural projects. The economic impact was almost immediate as growth averaged about 10% between 2009 and 2011. It was dubbed the China Dream, a new reality for a country ready to take its rightful place in the international space and whose citizens could not afford to be left behind. The stock market remained the best place for citizens and corporations alike to live the dream. By 2012, over 2400 companies were listed on the stock market, with over 200 million trading accounts active in the country. The majority of these investors (over 80%) were classified as retail traders, with the minority few being institutional investors. Nonetheless, the markets continued rallying higher and higher.
The majority of companies in China are state-owned, which makes it difficult to divorce political interests from economic interests. While the Chinese markets are driven by fundamentals, there is more than enough political will to preserve stability and value. This meant that when the Chinese economy started to show a relative slowdown in 2014, the government was quick to step in to protect listed companies from market realities. Real estate prices started declining, and corporate debt was expanding, and the government saw a thriving stock market as the only solution.
The CSRC (China Securities Regulatory Commission) put measures that helped boost liquidity in the markets, but crucially, what it did not do, is what mattered most. The commission literally failed to raise eyebrows at companies that deserved delisting for failing to show promising performance in three consecutive quarters. Furthermore, state-owned media continued to encourage investors to pour money into the markets while shadow banking, as well as margin trading, also acted as other catalysts. Chinese stocks were trading at price-to-earnings ratios of 70:1 compared to a global average at the time of about 19:1. More and more regular folks were taking part in the stock market, and it became common for people to quit their jobs to focus on day trading stocks. In fact, it became easy for people to take loans against their homes to take up stock market investments. At the height of the bubble, margin borrowing represented at least 10% of the total market capitalisation on the two Chinese exchanges. The bubble was continually pumped until it popped in June 2015.
How the Bubble Burst
On June 12th, 2015, the Chinese stock market bubble burst, and within just three weeks, over 30% of the value of Class-A shares was wiped away. The Bank of England gave a damning illustration of the sheer size of this plunge, equating it to the entire GDP of the UK in 2013 and over seven times the size of Greek debt that at the time was a major source of risk in the global financial markets. The tumble, however, did not end there as there were other significant aftershocks in the markets.
On July 27th, 2015, the market tumbled over 8.5%, the biggest dip since 2007. There was another 8.5% dip on August 24th, 2015, a day that would be dubbed ‘Black Monday’. This was followed by ‘Black Tuesday’ on August 25th, 2015, when the market plummeted over 7.6%. There was relative stability towards the end of the year, but more aftershocks and volatility were to follow at the turn of the year.
On January 4th, 2016, the markets made a sharp dive of about 8%, triggering the new circuit breakers that had been instituted. A brief recovery ensued, but a similar downturn was experienced on January 7th, 2016. That same day, the CSRC suspended circuit breakers, citing that their existence helped promote irrational behaviour in the markets. Overall, between the 4th-15th January, the stock market had shed over 18% of its value. During the crash, the government intervened heavily in the markets, but while its efforts helped prevent a potential financial crisis, it is arguable whether it restored investor confidence.
The Government Response During the Stock Market Crash
The Chinese government immediately responded by cutting interest rates and devaluing its currency. This did not work, and by August 2015, margin conditions were relaxed to prevent impending defaults. Transaction costs were also lowered in an attempt to encourage investment. All these failed, and that same month, trading was temporarily halted. More interventions from the government then followed.
The Chinese government then proceeded to enforce a lock-up period that effectively prevented large shareholders from selling their holding for a period of 6 months. Large shareholders were defined as those holding at least 5% of a company’s tradable stock. The lock-up period was to end in early January, and with negative sentiment still prevailing, the authorities imposed a 6-month extension to prevent another round of panic selling.
Circuit breakers were also installed while same-day short selling was banned. The effectiveness of these measures would later be put in question. By January 2016, circuit breakers had been triggered three times, prompting their suspension. Short selling would also be restored when its importance in the markets became all too clear- it is the short-sellers that buy stocks during a market downturn.
What Caused the Chinese Stock Market Bubble in 2015?
A major reason for the bubble was that the Chinese stock market was due for a market correction as the economy started cooling off. The period during 2014-15 saw the stock market diverge with real economic fundamentals, and it was clear it was entering bubble territory. It did not help that the stock market was witnessing more retail investing pumping money into it. Over 40 million trading accounts were opened in the 12 months leading up to the bubble, most of which were owned by retail investors and not professional money managers. Inexperienced investors rely more on rumours and hype rather than business fundamentals and the economy. Most of the amateur investors also traded on margin and made speculative bets that are not backed by research. Margin trading was particularly responsible for the irrational behaviour exhibited by the retail investors. They rode their luck, and greed set in as they sought to book outsized profits out of a market that seemingly had no ceiling. They helped fuel the bubble and also amplified the resulting dump.
The Chinese government must also be apportioned its fair share of the blame for the bubble. In a bid to salvage debt-ridden and poorly performing state-owned companies, the government, through the CSRC, relaxed margin trading conditions. State-owned media also openly encouraged the public to invest in the stock market, and they managed to lure a poorly educated retail investing group that would be battered severely in the markets. The ruling Communist Party also actively advised its members (over 88 million at the time) to participate in the China Dream through the stock market. In every sense, the government promised a never-ending bull run in the stock market, but investors would instead be stuck in a bear trap, many of them with hefty debt obligations to both formal and informal lenders.
Final Word
China has witnessed an incredible rise to global prominence in recent decades. But the Chinese stock market bubble and burst in 2015/16 provides lessons on the dangers of fast-growing economies. The stock market heated up during periods of fast growth, but a relative slowdown did not inspire anxiety among investors. The importance of institutional smart money was also underscored because the amateurish retail investors were not capable of accurately pricing stocks or exercising rational thinking in the markets. To this date, the Chinese market remains an intriguing market that is inherently risky even for professional and conservative investors. The source of risk is not limited to inexperienced retail traders but also the Chinese government itself that continues to exercise highhandedness in the local stock market. China remains a lucrative market with positive fundamentals, but the stock market crash of 2015-16 clearly shows that underlying risks exist.
