China's bubble burst after an expansion driven by superstition

Chinese government policies succeeded beyond expectations in boosting the stock market as investors fuelled a speculative boom. Prices rose around 250 per cent in around two years, including a rise of 26 per cent in a single month. Daily turnover quadrupled. At one stage, more than 500,000 new trading accounts were being opened weekly. China’s stock market expanded rapidly, overtaking Japan’s to become the world’s second largest.

Retail investors played a major role in the rise of share prices. In the reverse of the position in developed equity markets, Chinese retail investors rather than institutions dominate turnover, accounting for up to 90 per cent of daily trading. There are probably more than 100 million share trading accounts (around 8 per cent of the total population), which compares favourably with the 88 million members of China’s Communist Party.

The average investor is middle to low income, with more than 60 per cent lacking a high-school diploma. Much of the trading is speculative, driven by the lure of seemingly easy money, and much is short term, with very high intraday activity. At the height of the boom, trading activity on Chinese exchanges was greater than anywhere else worldwide.

Trading was driven by superstition including astrology, numerology and charms. In an echo of the conditions before the 1929 crash, one investor admitted to investing on the advice of her hairdresser. In June 2015, prices corrected. No clear, single factor appears to have triggered the price falls. The market simply ran out of momentum and investors lost confidence.

The effect of falling prices was amplified by the leverage, in the form of margin loans. At its peak, these reached around $350bn, around 12-14 per cent of the stock market size. In comparison, the level of margin loans is around 5-6 per cent in the US and 1 per cent in Japan. Falling prices triggered margin calls, forcing liquidation of positions as investors needed to raise cash or could not meet demands for additional collateral.

As the market plummeted and price changes became disorderly, authorities responded with a mix of communist propaganda and capitalist tricks. The media blamed short sellers and market manipulators. Patriotic calls sought to discourage investors betting on price falls. Chinese police instigated ritual investigations into short selling to scare even legitimate sellers out of positions.

Following the emergency plunge protection guidelines patented by the US authorities, the Chinese central bank pumped money into the financial system. Interest rates were cut. The reserve ratio and loan-to-deposit limits were altered to allow banks to increase lending. Margin finance rules were relaxed allowing anything from property to antiques to be used as collateral for loans.

As the rout continued, the government-controlled Securities Association of China arranged for the 21 big brokerage firms to establish a fund worth around $20bn (£13bn), to buy shares in large companies. China’s securities regulator banned major shareholders (with stakes exceeding 5 per cent), corporate executives and directors from selling their shares for six months. State-owned enterprises (SOEs) and investment vehicles were instructed not to sell shares. There were suggestions that some SOEs may buy back their own shares to support prices. New listings were deferred. With planned share offerings exceeding $600bn, the authorities sought to limit the claims on available investor funds.

Beijing encouraged companies to apply for trading halts. This resulted in suspension of trading in about 1,400 companies listed on Chinese exchanges, representing more than $2.5 trillion worth of shares, or 40 per cent of the stock market capitalisation.

Eventually, the market stabilised, regaining a part of the fall. The intervention mainly helped the share prices of big SOEs, such as PetroChina. The broader market, particularly small-capitalisation stocks, remains fragile. After the 30 per cent fall, the Chinese market remains 70 per cent above its mid-2014 levels.

But stock market valuations remain stretched. Even after the recent drops, Chinese shares, particularly in technology firms, are not cheap. The post-crash median valuation of stocks on the Shanghai and Shenzhen exchanges is almost three times that of the companies listed on the Standard & Poor’s 500-stock index. Margin debt levels remain high.

Given the centralised political and economic command and control in China, it is unwise to assume that the authorities cannot prop up share markets. Large foreign exchange reserves ($4trn) and the ability to use state-controlled banks to expand balance sheets gives the government plenty of scope to buy shares.

But expanding credit risks increasing inflationary pressures and further complicating the task of dealing with a large pre-existing credit bubble. Intervention might push up the value of the Chinese yuan, cancelling out today’s devaluation and making China’s embattled exporters even less competitive. Chinese authorities are discovering an old truth – bubbles are hard to see and even harder to catch.

Satyajit Das is a former banker and author. His latest book, ‘A Banquet of Consequences’ (in Australia and Europe) or ‘Age of Stagnation’ (North America and Asia), is out shortly