Recently, extreme volatility that affected the Chinese equity market has ignited a great amount of public and professional attention and debate. The speed at which these events have unfolded and the impervious nature of top government policy-making concepts in China remain questionable. While the world attempts to classify the Chinese share market as a casino or a gambling hall with no economic reality, the recent tremors have sent shockwaves across the world through the global investment market. This situation can be equated to the Greek’s exit from the Euro zone market.

This recent economic bubble is neither the first nor the worst in the fledging stock exchange of Shanghai. The period between 2005 and 2007 saw the benchmark Shanghai Composite Index jump six times from 1000 points to 6000 all of a sudden and then fall back to 2000 (Roth, 2014). The 2007 burst can be explained by the exuberant development of the China’s economy, but the current surge is not connected with economic growth. The China’s economy has been growing slowly from double digit rate of 7.4% in 2014 during the boom period to an average of 7% in the June quarter (Cooke, 2015). However, the recent figure was better than it was anticipated because it could falsely boost the investor’s confidence both in China and abroad. This research paper provides a brief analysis of possible causes of the present situation, actions taken by the government to resolve it and the impact of Chinese market turmoil on investors and the economy.

Shanghai Composite Index (SSI)

This is the biggest stock market in China that includes all stocks that are traded in China (both A shares and B shares). The Composite Index is similar to the American version of the Dow Jones Industrial average (DJIA) and is basically used to track the most important and biggest public companies in China. Although the creator’s intentions were to track how large Chinese companies perform, it became one of the most observed international benchmarks. It is also used by investors as an informal way of determining the health of the Chinese economy (Carbaugh, 2013). The SSE Composite Index is a recommended way of getting a broader overview of all the companies listed in the Shanghai stock exchange. In addition, there are more selective indices like the SSE 50 index as well as the SSE 180 index that are used to demonstrate market leadership by the degree of their capitalization. It is likely that over time the SSE Composite will become a mirror that reflects the overall economy of China. The government is encouraging most state-owned energy, banking and healthcare companies that are yet to go public to get listed with the SSE. This will facilitate illustrating the economic development of China by considering the data obtained from the stock market and other economic indicators captured by the government.

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What Happened

The Chinese equity market precipitously falls after a stratospheric rise in 2014. This fall has been alarming both in speed and in scale because over $3 trillion of market capitalization evaporated without a trace in the slide of 30% since mid-June (Roth, 2014). Despite this considerable decline, the market value is still relatively high. Thus, Chinese equity market has increased by over a hundred percent in the last 18 months (Cooke, 2015).

The massive fall at the international market was awash with liquidity that encouraged investors to develop an open Chinese capital market and increase the probability of having fundamental reforms. The Chinese market continues to growth steady at a slow rate as compared to the rest of the world. Moreover, there is a conviction transition from a low cost manufacturing model to service and consumer-led economy is the main reason for it.

As the tendency to invest progressed, the fundamental principles of investment declined and caused speculation at the market. The rate of margin lending increased to the level that exceeded any other market in the entire world throughout history. Incremental buyers quickly turned to investors, seeing the opportunity to cash in on the ascent of ‘free money’. According to a survey by the Chinese Household Finance, an average stock market investor in Shanghai had not even graduated from high school and invested with a high leverage through margin loans (Gan et al., 2014). This vibrant stock market had an ability to transform China from its heavy reliance on bank lending to more economically viable investment (Weisenthal, 2015). More specifically, when growth slows down, the equity market can serve as a means of de-levering highly indebted financial and commercial entities. However, there exists a high disconnect between valuation of investment and the underlying fundamental eventualities, which become so extended that they result in a speculative bubble the Chinese market rolled over. The falling speed of this market was so high that the Chinese authorities were clearly anxious.

Nonetheless, the authorities have dramatically intervened by easing the rates and reserve requirements, interrupting the IPO activities, pledging the support of state pension fund and injecting more money into the brokerage houses in order to extend margin loans. The government authorities have also forbidden any insider sale or that connected with major shareholders and involved the Ministry of Public Security to arrest those who maliciously sell stocks and stock index futures.

Possible Explanations of the Situation

Soaring of Debt Levels

The main difference between the current and the previous share market crash is the amount of shareholders with a new mindset who are armed with margin loans. Between June 2014 and May 2015, there were approximately 40 million new stock market accounts that were opened, increasing the total number of trading accounts by more than 50% to equal 90 million (Cooke, 2015). When debt was added to the mix, there was a rapid rise and fall of share prices that were bound to increase. By June 2015, the Chinese investors had purchased stock worth approximately $350 billion with borrowed money alone. This situation illustrates how far individuals were willing to gamble even with margin loans. Most of them were using their own stock as security for loans from financial institutions, thus placing a bet on commodities and share market (Weisenthal, 2015). This explains why the investors, listed companies and financial institutions were badly hit by the margin calls, even when the share prices soared and the market broadened.

The Dollar and Devaluation of Chinese Currency

Amid uncertainty surrounding the falling commodity prices in both China and Europe, international capital has been flowing to safe haven assets like the US and Euro bonds, thus increasing the value of the greenback. In the wake of China’s market crash, the AUD fell for the first time in six years to a value slightly below the US73c. China’s rapid growth from a developing to a developed country in less than five decades and practicing a more open market is bound to create some development constraints along the way. The recent market meltdown exposes the need to have more stringent economic reforms in the country. It should also serve as a reminder that what is favorable for China’s economic development is equally good for the rest of Asia and those who invest its economy. The board has been investigating the long term impact of Chinese market turmoil in China, the second largest economy, as well as the domino effect I has on other countries in Asia (Cooke, 2015).

Risks of Chinese Market Turmoil to Foreign Investors

Access of foreign investors to the Chinese mainland is usually limited by government quotas, which were recently expanded though. Foreigners own approximately 4% of A-shares in China that are traded on the mainland exchanges by the local securities. This differentiates the kind of investment from H-shares traded in Hong Kong stock exchange and N-shares comprising Chinese stocks traded in the US. Furthermore, China is the second largest economy in the world that has numerous trade ties with many foreign firms and individuals. Chinese business activities in the world accounted for 38% of the total GDP in 2014 alone, which is the largest share by a single nation (Cooke, 2015).

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According to Steinberg (2015), prolonged weakness of the stock market causes Chinese economy to disintegrate further, thus troubling other nations and the global economy at large. Moreover, the depth and speed at which the Chinese stock market suddenly descended prompted unprecedented intervention by the government, drawing attention to the risks involved in foreign market investment. Although foreign investors may not stand to lose much due to the high restriction in the Chinese stock market, there is a high possibility that devaluation of Chinese currency may affect their trade with China in the long run.

China’s Real Estate Investment in Australia

The financial turmoil in China has driven China’s stock market investors to seek safe havens in real estate development in Australia. The increase of China’s presence in foreign property market investment has increased as intelligent individuals and companies aim to keep their money in stable economies abroad. In Australia, the Chinese topped the US investors as the biggest source of foreign investment in real estate in both 2014 and 2015 financial years. The Australian authorities began to worry that wealthy Chinese investors would flood more money in the already overheated property market.

Although the Chinese share market is not linked directly to the global economy and the financial system, the uncertainty with China’s monetary system and government’s actions to respond to it is essential for Australia. As the China’s bubble continued to grow, the prices for real estate in Australia reduced by 30% within a fortnight to as low as $ 45 before making some recovery. The main reason for this slump lies in the fact that these commodities have long been used by investors as collateral for bank loans and the individuals were forced to sell their commodities to meet the margin calls of their shares. The price volatility situation is likely to continue provided that the prices reduce.

Government Intervention into Chinese Market Turmoil

The Chinese stock market turmoil surprised not only the government but even the experienced traders. However, with more losses expected from Australia and some Asian countries, economic analysts believe that there is a need to maintain a long-term policy through government intervention (Roth, 2014). The implosive prices of Chinese equity following a debt-fueled buy stock buying binge have also triggered a range of reactions from investors and governments from both local as well as in the international arena.

Reaction of the Market in Case of Slow Bull Implementation

Slow bull market is a situation when the government regulates the market. This situation can be favorable to the economy but devastating to individual investors, who may be required to pay more for debt financing compared to a free market situation. This means that the cost of investors who strive to make quick profits in the stock market would not be able to achieve this objective but will suffer loss in return. A slow bull stock market implies that the stock growth is regulated by progress at a slow pace. This pace may be less than the interest rates offered by the banks and the inflation rate in China. Therefore, investors would run at a loss, while the economic progress would be negative. The investors and brokers would protest against this move because it would require them to shift their investment focus to unsafe foreign investments.

Effect of Introducing Off- Exchange Market Leverage

Off-exchange market or over-the-counter operations is a kind of trading executed directly between two parties without any particular supervision in terms of exchange. This is opposite to exchange trading that is undertaken in exchange markets. Stock exchange is important because it facilitates liquidity in the market and mitigates risks that may arise in case one party fails to follow the terms of the transaction. The existence of a strong structure shapes the orderliness and stability of the entire market place. Off-exchange market does not only comprise informal trading but also financial instruments, derivatives and commodities. The products traded in this market have to be highly standardized because the exchanged derivatives reflect a narrow range of quality, quantity and the identity, which is defined by exchange that is similar in all transactions. These conditions are essential for transparency in trading. As the market does not have many limitations, the trading parties might agree to unusual quantity, quality or prices.

Over-the-counter exchange in the stock market refers to a system where stocks are traded through a brokerage firm rather than through a centralized system. Unlike centralized exchanges, OTC markets are well organized although they are less formal. Dealers become market makers who determine the prices through quotation and ask sellers and buyers whether they are willing to sell or buy at the mentioned price. However, they do not necessarily quote the same price to all customers because different customers come with different needs and preferences. In addition, dealers in this situation can withdraw market making at any time without restrictions.

Therefore, if China opts for this kind of market, the situation can escalate and become even worse than it is with a centralized stock exchange. This is because dealers and brokers can collude to corrupt the market. Market players can manipulate the market for their own benefit, leaving the economy to collapse. The freedom of withdrawing from the market that is given to dealers can lead to liquidity drainage, thus disrupting the ability of market participants to sell or buy. Stock exchange is far more liquid because all participants buy and sell orders and execution prices that are exposed to one another. Another risk with OTC is that they are less transparent and their operations are executed through fewer rules that favor brokers unlike centralized exchange, where there is a level playing ground for everyone. For example, in 2007, all securities and derivatives that were involved in the financial turmoil in the US mortgage market were traded through the OTC market. Therefore, any attempt by the Chinese government to introduce off-exchange market would result in disaster.

Implications of Government Declaring to Stop the High Leverage Margin Trading

The Chinese investors have adopted the culture of borrowing from banks to invest in the stock market. This implies that the highest amount of investment was from borrowed capital. In financial terms, leverage is a situation where a person reinvests debts in an effort to earn greater returns that the interest costs. When an investor uses a considerable amount of debt in investment, it is considered to be highly leveraged, which implies that the gains and losses are equally amplified. Margin is a form of borrowed money that is used to invest in various financial instruments like bonds, bills and stock market. Just like the situation in China, margin is often used as collateral to security holders or holders of futures to cover the risks of credit of his/her counterpart. The concept of margin and leverage are interconnected because one can use a margin to create leverage and vice versa.

Therefore, stopping high leverage trading margin in China would allow individuals to use their own capital and assets to invest in the stock markets instead of the borrowed capital. In addition, investors will have to reduce the investment risks by providing finance without interest on debt. Leverage amount is expressed in ratio with one side describing the ratios of cash and the other side describing the amount of debt that can be taken proportionately to the amount in the account. Leverage is risky for risky businesses and profitable for profitable ventures. In reducing the amount of leverage, the government would reducing the amount of capital invested in the stock market, thus decreasing the volume traded and the tax obtained from transaction costs (Roth, 2014).

However, stopping leverage completely will mean that most of the investors will pull out of the market, which may negatively affect the stock market and the economy. Lack of leverage will reduce shareholders return on investment by denying investors the ability to take more high return investment and enjoying a tax advantage related to borrowing. Margin collateral such as securities or cash can be deposited into a bank account to cover credit risks that cash investors are required to absorb when they have a position in securities, futures and options.

Conclusion

Over years, investors have preferred stock market relative to the bond and commodities due to their solid nature and relative valuation although they are not spectacular representatives of the global economic growth. Recent changes in the Chinese stock market should be considered by investors who believe equity provides the most relevant economic fundamentals. Stocks in Japan and Europe may also be considered to possess price volatility experienced in China given that monetary policies support structural changes. Therefore, investors should take more caution when trading in the emerging markets unless headwinds of different commodities in different economies decline.

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