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Chinese stock market, which has risen to stunning heights since the middle of the last year, plummeted back to Earth last week. Subsequently, it rebounded sharply on Thursday and Friday, as the Chinese Government decided to intervene in order to restore faith in the market and calm down panic-struck investors.

The ongoing situation in China is often referred to as the biggest stock market bubble since the dot-com boom. The scale of the market moves can be seen on the below chart of the China50 index.

ACFX introduced the China50 recently as a new product. The China50 is an index composed of the 50 largest companies by market capitalization that are traded on the Shenzen and Shanghai Stock exchanges.

What are the possible repercussions of such a meltdown for the Chinese economy and the global financial markets?

The strong falling trend was reversed on Friday with the Shanghai market rising 4.5 percent. However, the two main stock exchanges are down dramatically since hitting a peak on June 12. The Shanghai Composite Index has lost more than 25% of its value over the last four weeks, whereas the Shenzhen Composite Index has fallen by 35%. Nevertheless, both markets are up more than 80% compared to mid-2014.
So is there a reason to be worried? Why did panic spread in a pervasive manner among the investors?

According to Bloomberg’s China Market Cap index, Chinese listed stocks have lost $3.6 trillion in value by July 9. For the purpose of comparison, the GDP of France amounts to $2.81 trillion.

The Chinese Government depicted this market movement as panic selling and brought a decision to implement certain measures to prevent the market from falling even further. More specifically, it cut the interest rate for the fourth time this year, prohibited short selling, postponed initial public offerings (IPOs), liberated the rules to allow the pension funds and the social security funds to invest more in equity markets, and banned the sale of shares by the shareholders owning more than 5% of outstanding company’s stock. In addition, it changed the rules so that now investors can, for the first time, use their real estate as collateral to borrow money and invest it in stocks.

I am emphasizing this because I find the role that lending has played rather important. Namely, one way the money was flowing into the stock market was through margin lending, where brokers lend money to their clients who then use it to buy stocks. This increase in margin lending came as a consequence of expansionary monetary policy and years on interest rate cuts.

As Scott Kennedy from the Centre for Strategic and International Studies has explained, “Over a quarter of China’s stock market capitalization is now supported through margin financing, turning an equity market into a de facto debt market”.

According to Goldman Sachs, the sudden fall in prices was caused by investors using borrowed money to enter the market and then being forced out of the market by declining prices. Analyst Kinger Lau and his team contend this “deleverage cycle” is two-thirds of the way through.

Most market participants would agree that the stock prices were not reflecting fundamentals which created the bubble that burst one month ago. However, there hasn’t been much contagion from equity markets so far and more importantly the risk of contagion is likely to remain low due to the fact that foreigners own a small percentage of Chinese stocks. Therefore, the impact on the global economy is expected to stay rather limited in the short-term.

On the contrary, the big danger for the Chinese economy lies in the fact that the further slump might force investors who bought shares on margin to sell stock in order to pay their brokers. Some companies have used their own shares as a collateral for bank loans which implies that, in case the share price falls below a certain threshold, they may default.

Only time will show whether the Chinese economy is capable of getting out of this meltdown and building a more sophisticated financial system.

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