by Ryan Ong
CHINA was an exciting place to be last week, but only in the same way Iraq has been. In a series of sudden plummets, China’s stock market lost around 30 per cent of its value in less than a month, and the government applied literal brakes on the trading. Here’s a simplified explanation on what’s going on, and how it may affect you:
What happened in China?
From January 2014 to June 2015, China’s stock market surged in value. The Shanghai Composite index, one of China’s two main stock exchanges, rose by 150 per cent. If you’re not into stocks, just imagine an investment that more than doubles your money in six months – it was that good.
But around 12th June 2015 (the peak), the market started to dip. No one panicked, because they figured it was either a correction (the market falling to normal levels after a strong rally), or that it would recover.
Well the market decided otherwise, and instead plummeted like a fat man with a broken bungee cord. In less than a month, the Shanghai Composite index fell 25 per cent, and the Shenzhen Composite fell 35 per cent. But those percentages don’t do it justice. Look at it in terms of dollars and cents:
Around $4 trillion in share value was lost.
Do you have any idea just how much money $4 trillion is? A roomful of teenagers wouldn’t cost that much in-game damage in Grand Theft Auto V if they played for a year. The Greek debt looks like a homeless man’s spare change by comparison. Also, the Singapore stock exchange is worth about $978 billion. If we suffered a similar loss, it would be enough to wipe out Singapore four times over. In less than a month.
This was followed by a 4.5% recovery in the Shanghai market last Friday, thanks to the Chinese government’s efforts. But that’s about as relieving as finding a small glass of ice cubes in the middle of a house fire.
What caused it?
As always, it is not easy to determine exact causes of stock market crashes. Many factors contribute to one, and a great deal of speculation is involved. But these are probably the main culprits, in order of importance:
- Over-leveraged investors and media hype
- Toxic financial products
- Panicked wave of sellers
- Over-leveraged investors and media hype
If you look at China’s stock market growth from 2005 to 2007, you’ll see it coincides with China’s growing economy. If you look at their stock market during the 2008 financial crisis, you’ll see it contracted. That makes sense: the equities market grows or shrinks with the country’s economic output.
But the surge in China’s stock market in 2014 coincided with slower growth in the Chinese economy. That breaks the rules: how can the equities market rise 150 per cent, when the companies that those shares reflect are slowing down?
The answer is over-leveraged, overeager investors.
Starting in 2010, the Chinese government gradually lowered restrictions on margin trading (the practice of investing in stocks with borrowed money). The more lenient a country’s rules on margin trading, the easier it is for the average citizen to invest in its stock market.
China’s state media and brokerages actively encouraged Chinese residents to do this, as they believed it would help grow the economy.
But the surge of money drove stock prices sky high. Companies ended up with stock prices way above their real, intrinsic value. It is quite similar to the dot com bubble in the 90s, when millions of dollars were thrown at companies that had no proper revenue or growth plan.
But prices inevitably correct themselves, because when the businesses fail to perform as expected, the share prices drop.
Now if said share prices were a little bit higher than were correct, that might mean a loss of a few hundred dollars. But for someone who bought the shares when they were inflated way past their real value (near the 12th June peak), they’re looking at a fall that wipes out a quarter or a third of their total investment.
When this started to happen, it resulted in a wave of panic selling (see point 3).
- Toxic financial products
For those who didn’t invest in shares directly, many Chinese banks offered toxic financial products that exposed them to it anyway. These Wealth Management Products (WMPs), although they may as well be called Weapons of Mass Poverty in this context, are high risk, complex investments.
At the simple end, some WMPs work like structured deposits – you commit your money to the bank for the length of time, the bank invests it in…something, and if it works you get a return on your money. The functional word being “if”.
China’s WMPs promised unusually high returns (five to eight per cent), often with no principal protection (that means you can lose even the initial sum you invested.)
As with structured deposits, these WMPs are dangerous products because few people understand where the money goes. Very often, the money is invested in risky assets that are poorly regulated, or completely “off the books”.
Another form of WMPs seem to be a close imitation of the Collateralized Debt Obligations (CDOs) that devastated the United States in 2008. These WMPs are tranche products: the investors are divided into slices (called tranches) ranging from the most senior to the most junior.
Investors in the junior tranches get higher returns, while those in the senior tranches get lower returns. In the event of losses however, the investors in the junior tranches absorb the losses before those in the senior tranche. Here’s a simplified diagram*:
(*The following is not a direct or indirect reference to any specific bank’s products. It is only a general description of a form of tranche product.)
Here we have the divisions between investors, who are making a combined investment of $10 million. The most senior tranche, which may be reserved for the bank itself, will get the lowest returns.
But look what happens in a loss scenario:
The investment doesn’t work, and there’s a loss of $6 million.
The most junior tranche absorbs this loss first. If the loss wipes them out, the loss then moves on to the next most junior tranche, and so on – until the entirety of the loss is absorbed. The senior tranche has a good chance to come out unscathed. This is the reason junior tranches offer such high rates of return.
Now in places like the United States and Singapore, tranche products are mostly sold to institutions (e.g. insurance companies, large mutual funds, and so on). These institutions have – in theory – the ability to work out the risks and absorb the losses.
But in China, many of these products were sold to individuals. When the crash came many were in the junior tranches, getting mowed down like WWI infantry.
Now this is good news for the Chinese economy as a whole, because its major institutions aren’t declaring bankruptcy.
It’s not so great for the individual Chinese citizens who made these investments. You may recognize this as exactly the kind of thing that makes poor people angry at rich people, which is why the Chinese government is in damage control.
- Panicked wave of sellers
Everything in points 1 and 2 have convinced existing investors to run for the exit. This mass selling drives stock prices downward very quickly, and once the momentum is gained it’s very difficult to stop. This kind of panicked sell-off is not specific to the Chinese situation, and is the expected result of most stock market crashes.
The Chinese Communist Party (CCP) dealt with this in their usual subtle manner: by outright suspending trading, and telling organizations to buy stocks. I’m going to go ahead and imagine they did so with a lot of black, unmarked cars parked outside, because it’s not easy to persuade people to buy into a market that just lost $4 trillion. For publicly listed companies, many top level executives were told to buy back their stocks and barred from selling.
They also started the China Securities Finance Corp. (CSFC), which grants credit (more margin trading!) to organizations looking to buy stock. It’s hoped that these measures will put the money back in.
How will this affect us?
We’re either in a lot of trouble, or not at all – nothing in between. Consequences depend on whether the Chinese government is able to stem the rout, and how much of their assets Chinese citizens have put into equities.
If it turns out that a large number of China’s population had a sizeable investment in stocks, then we’re in a lot of trouble. Mass poverty could result in backlash against the CCP, and political instability in China will make waves around the world – China accounts for 17 per cent of the world’s Gross Domestic Product (GDP), beating out the United States by one per cent. Many companies are invested in China, or depend on China for their supply of manpower and manufacturing facilities. If a revolution breaks out there, you can bet the prices of goods almost everywhere are going to soar.
But odds are, the Chinese government can keep it under control. That’s one of the advantages of not being a democracy (an advantage to the rest of us, that is. I don’t know how much it benefits their own citizens).
It is strategically crucial for China that the stock market rout not destroy confidence. Part of China’s “silk road” strategy, which pits it against the US in terms of trade deals, requires that they develop a reputation for a stable, more open economy. Investors in China would do well to monitor international reactions to Beijing’s coping strategies in the next few months.
Featured image by Shawn Danker.
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