The stock prices in China have been declining sharply since June 2015. On 24th August 2015, the stock prices fell by a massive 8.5%. It was the biggest one-day decline since the financial crisis of 2007 and was dubbed as “Black Monday”.
Why did it happen?
Stock markets are the indicators of the health of the economy. It goes up when the economy is growing and vice versa. In China, stock market indices had increased by around 150 % in the period between June-2014 to June-2015. But, the main problem was that this sharp increase did not correspond with the economic health of the economy. During the same period, growth in China came down to 7 % from over 14 % in 2007. Its manufacturing industry which contributed the most to its GDP also slowed down.
This was a case of a bubble and it had to burst eventually. The prices in stock markets did not correspond to the macroeconomic fundamentals of the Chinese economy. The markets were overvalued.
What led to the bubble in the stock markets in the first place?
As the export-led growth rate of China slowed down, China liberalised its stock market to encourage investments in its economy.
- It lowered the interest rates and, therefore, cheap credit was available to invest in stock markets.
- It made it easy for the investors to borrow by using their property as collateral.
- It also relaxed regulations related to margin trading (explained later)
This easy availability of borrowed money and relaxed regulations lured Chinese people to invest in stock markets. This led to an increase in prices of shares as more and more people borrowed money to invest in stock market and inflated the prices.
The fact which worsened this situation was that majority (around 80%) of its investors were inexperienced retail investors and they tend to have a herd mentality.
What is margin trading?
Margin trading allows an investor to invest in shares with borrowed money. Say, I want to buy a share worth Rs. 100 from the market. I can borrow a part of this amount from my stock broker. If the margin requirement is 70 %, then I will have to pay Rs. 70 and I will be allowed to borrow Rs. 30 from the stock broker to invest in a share worth Rs. 100. So, lesser the margin requirements, the more I can invest in the stock market with less money in my pocket. The Chinese Government had done exactly this to boost the stock market. They lessened the margin requirements and retail investors began to flood the stock markets with borrowed money.
Why did the bubble burst suddenly?
The prices came crashing down suddenly because the Chinese Government had realised that the stock market had become overvalued and began taking steps for its corrections. In June 2015, it began to tighten the financial market regulations and increased margin requirements. Therefore, markets crashed in June.
On 11th August, the Government devalued renminbi (China’s currency) to boost exports. It was taken as investors as a sign that the Government has admitted that the slowdown is for real and it led to further loss of confidence in the stock market. People began to sell their shares and the prices came crashing down.
What steps have the Government taken to arrest the plunge in stock prices?
- It has limited short-selling. (It is a way in which investors sell shares before buying it. If an investor expects a share price to fall, it will borrow the shares from a broker at a rent and sell (or short) it. Later, it will buy the shares from the market and return it to the broker.)
- It has stopped listing of new shares.
- It has decreased the margin requirements.
- It has ordered large institutional investors like mutual funds and pensions to buy shares.
- It has suspended trading in shares of companies.
But, why has China’s economy slowed down when it has been growing so rapidly since a decade?
It happened because its growth model was unsustainable. China’s growth relied heavily on investment and exports and consumption formed a very little part of its GDP. China’s export demands have come down, because of a slowdown in the world economy. Also, excessive investments have led to overcapacity. China needs to switch to a consumption-led growth model.
What is the impact of this slowdown on India and on the world?
- China will not serve as the engine of global growth and its ripples will be felt across the world, in the form of low world growth rate [developed economies are already struggling with low growth in the aftermath of the financial crisis and the eurozone debt crisis.]
- China has been the biggest importer of commodities like iron, aluminium, copper, oil etc. to undertake its investments. Now that its economy has slowed down, the countries like Australia, Zambia, Nigeria, Chile etc. which exported these commodities to China will be the worst hit.
- Also, prices of commodities have declined further due to lack of demand from China. India will benefit from this decline in prices of oil and other commodities as it will enable it to invest more in infrastructure.
- As China has devalued its currency, its exports will become cheaper. It will reduce India’s export competitiveness in the world market.
- As people look for safer investment options, prices of Gold etc. will increase.
In summary, China’s stock market decline happened because of the slowdown in the economy and the stock prices had to come down to reflect the true picture.
This is the end of the crash:) Please leave your feedback on the comments section