The Great Chinese Financial Meltdown of 2015?

"China’s authoritarian and opaque political economy under the Chinese Communist Party is about to be tested in its most severe way since Tiananmen Square in 1989."

The Chinese stock market has been much like a giant casino in 2015. Chinese investors, many of them using their hard-earned savings, have placed their bets and watched the wheel of fortune spin. Through much of 2015, this was the right bet. The returns were substantial—according to the Financial Times on July 6, 2015, China’s equity market has doubled since June 2014.

For a population looking for yield, the rising stock market has had a siren-like appeal, sucking in Chinese investors’ money and roaring along—even as economic activity cooled.  Since mid-June 2015, however, the stock market boom now appears to be going bust and small investors who came late to the party are likely to be caught by the old saying, “the devil takes the hindmost” (those who lag behind will receive no aid).

One of China’s hottest markets, the Shenzhen Stock Exchange Composite Index, hit its peak on June 12, hitting 3140.66 points, up from 1436.86 at the beginning of the year. The Shenzhen Index is now under 2000.00 and the trend-line is down. According to Bloomberg, the July sell-off in Chinese equities wiped out $3.2 trillion in market value in three weeks. As of July 8, 1,476 companies, more than half of China’s 2,808 listed companies, have suspended trading in their shares. Foreign investors are fleeing. For President Xi Jinping and the ruling Chinese Communist Party this is not good news.

The Chinese stock market’s spectacular rise was part of a deliberate effort by the Chinese government to help push the economy along. The authorities moved to give China’s economy an asset value boost, certainly something that fits the accommodative central bank positions in the United States, European Central Bank, Bank of England and Bank of Japan.

The reason for the asset boost in China must be observed by the landscape facing Chinese policymakers—an economic slowdown that is expected to be multi-year in nature, an aging population that has substantial questions about how to finance its “golden years,” credit misallocations since 2008-09 (lots of money flowed into a troubled real estate market), and rising corporate debt. The equity boom move was critical to dealing with the last as indebted state-owned enterprises (SEOs) could (and did) dump inexpensive loans for equity raises.

The stock market boom was helped by leverage. According to the Financial Times, the margin of debt outstanding expanded sevenfold since the start of 2014 and June to stand at 1.4 trillion (from $225 billion). As long as cheap credit is available, it functioned as a fuel to keep the stock market machine moving along—at least until confidence eroded, which is what happened beginning after the markets peaked on June 12.   

The authorities are fighting hard to stop the slide in equity markets. In order to take measures, the central bank, the People's Bank of China, has made four interest rate cuts since the end of 2014, lowered reserve requirements on a steady basis, introduced Pledged Supplementary Lending (PSL) to provide banks cheap funding against the collateral of local government bonds and expanded its balance sheet by lending to domestic banks. Other measures have included encouraging brokerages, many owned by the government, to buy stocks. Moreover, state pension funds will be allowed to buy up 600 billion yuan of equities. According to Reuters, China’s cabinet has approved the country’s largest pension fund to manage funds worth about 2 trillion yuan ($322 billion) for local authorities. In July, the authorities even moved to ban major shareholders, corporate executives and directors from selling stakes in listed companies for six months.

The problem for China’s authorities is that confidence in the market—which appeared supreme through most of 2015—is eroding. The Chinese state has sought to guide the stock market’s direction. While this worked for a period, the stock market is increasingly a point of worry for investors, especially those in the country’s emerging middle class who are observing the economic cooling with growing trepidation. Simply stated, accommodative monetary policy and support for bolstering asset valuation is colliding with deteriorating Chinese economic fundamentals. This is evident in weaker external demand, overcapacity in some sectors and deflation.

If these factors were not enough, the government’s anti-corruption campaign is adding a chill factor for business leaders to create a higher profile for success. The Financial Times’ George Magnus observed: “The anti-corruption campaign unleashed by President Xi Jinping is sapping growth and initiative and stifling economic reforms.”