Free fall: Why the Chinese market is slipping despite govt's booster dose

Nearly 1,300 companies which form around 45 percent of the Chinese stock market have announced trading halts. The shares of these companies cannot be sold or bought as of now. The Chinese stock market has been on a free fall over the last one month. By announcing a trading halt the companies want to ensure that their prices do not continue to fall. [caption id=“attachment_2333534” align=“alignleft” width=“380”] Worried about stocks. Reuters[/caption] The Shanghai Stock Exchange Composite Index has fallen by 31.7 percent over the last one month to close the day today (8 July 2015) at 3,507.19 points. More than $3 trillion of investor wealth (fall in market capitalisation of stocks) has been lost in the process. Even after this fall, the stock market is up by 69.9 percent over the last one year. The stock market is falling despite efforts by the Chinese government to prop it up. As The Economist reports : “Regulators capped short selling. Pension funds pledged to buy more stocks. The government suspended initial public offerings, limiting the supply of shares to drive up the prices of those already listed. Brokers created a fund to buy shares, backed by central-bank cash. All the while, state media played cheerleader.” Nevertheless, all this hasn’t stopped the stock market from falling. Before understanding why the stock market has continued to fall despite the efforts of the government, it is important to understand, why the stock market ran up as much as it did in the first place. Between 1 July 2014, and 8 June 2015, the Shanghai Composite Index rallied by 150 percent. Since then, as mentioned earlier, it has fallen by 31.7 percent. So what is it that caused the Chinese stock market to run up as much as it did? People’s Bank of China, the Chinese central bank, has cut interest rates thrice since November 2014, in the hope of pushing up economic growth, which has been slowing down. The idea with cutting interest rates, as always, was to encourage people to borrow and consume more. Nevertheless, some of this “easy money” made it into the stock market and drove it up by a huge amount. The central bank cutting interest rates was a short-term reason which drove up stock prices. There was a long-term reason as well. As Ruchir Sharma, author of Breakout Nations, points out in a recent column in The Wall Street Journal : “When China’s economy slowed following the 2008 global financial crisis, Beijing pumped massive amounts of liquidity into the system. First that money went into the property market, later into the various debt-related products sold through the shadow banking system. But when property slumped and the shadow banks started to pose systemic risks, China had only one major market left to flood—stocks.” And that is precisely what the Chinese government did by flooding some of the $20 trillion of Chinese savings into stocks. The idea was to allow the debt laden Chinese companies a new source of funding. With the government focusing on the stock market, it was only time that the Chinese retail investors started flooding the stock market. Further, as Sharma points out: “Today China’s 90 million retail investors outnumber the 88 million members of its Communist Party.” And many of these investors started trading on the margin. Margin trading essentially refers to investors borrowing money to buy stocks. Sharma estimates that nearly 80 percent of margin finance at leading stock brokerages is going to retail investors. Margin trading helps investors buy more stocks than they actually would be able to if they just invested their own money. It also helps them earn higher returns if the markets are doing well. This in turn leads to more money flowing into the stock market. This is precisely what happened in case of the Chinese stock market pushing up the price to earnings ratios of companies in the process. As Neil Irwin writes in The New York Times : “Just a year ago, Chinese stocks looked relatively reasonably priced, with a price-to-earnings ratio of around 10, meaning an investor paid the equivalent of about $10 for a share of stock that offered $1 per share in annual earnings.” By early June 2015, the price to earnings ratio had jumped to 26. The Chinese economy which was growing at a rate of greater than 10 percent all these years is now projected to grow at around 7 percent. Hence, there was no real reason behind the stock market rallying by close to 150 percent between July 2014 and June 2015. Investors should logically pay a higher price for a stock today only when they expect higher earnings in the future. But that clearly wasn’t the case in China. The only reason for this massive jump was a lot of easy money flowing into the Chinese stock market. And this easy money encouraged margin trading. The thing with margin trading is that it leads to massive profits while the going is good. But it also leads to huge losses when the going is not so good. Let’s understand this through an example. A Chinese investor decides to invest 10,000 yuan in the stock market. He earns a return of 25 percent or 2,500 yuan in some time. Now let’s say that the same investor decides to trade on the margin. He borrows 30,000 yuan and invests 40,000 yuan into the market. A 25 percent return pushes the value of his investment to 50,000 yuan. He decides to sell his investment and gets 50,000 yuan. In the real world he would have to pay an interest on the money that he had borrowed. But let’s ignore that for the moment for the ease of calculation (and the fact that it does not change the point I am trying to make, given that the interest rates in China are very low in the first place). The investor returns the 30,000 yuan he had borrowed. He is left with 20,000 yuan. Since he had invested 10,000 yuan, he makes a profit of 100 percent. When he had invested only his own money his profit was just 20 percent. Now this is the good part of borrowing money and investing it in the stock market. Let’s say an investor puts 10,000 yuan of his own money and borrows 30,000 yuan. A total of 40,000 yuan is invested in the stock market. The market falls by 10 percent. The value of the investment falls to 36,000 yuan (40,000 yuan minus 10 percent of 40,000 yuan). But the investor’s own capital is down to 6,000 yuan (10,000 yuan minus 10 percent of 40,000 yuan. This means a loss of 4,000 yuan or 40 percent. Hence, a 10 percent fall in the stock market leads to a 40 percent loss to the investor. In such a situation the investor is likely to sell out rapidly in order to limit his losses. In China’s case many retail investors were trading on the margin. Hence, a small initial fall would have led to many investors selling out. This would have led to a bigger market fall forcing many more investors to sell. And so the process would have worked. There is another factor that needs to be mentioned here. As a Reuters news report points out : “Unlike other major stock markets, which are dominated by professional money managers, retail investors account for around 85 percent of China trade, which exacerbates volatility.” (Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)