Just after we posted an article on China’s amazing stock market success in recent months, the bubble burst and the frenzied buying went into reverse. Last week was the worst since 2008. The CSI 300 Index, which tracks the 300 largest companies in China, experienced its biggest one-day loss in seven years last Friday.
The sharp stock market selloff occurred shortly after Morgan Stanley Capital International (MSCI) chose not to add Chinese shares to the MSCI Emerging markets Index, since institutional stock quotas are insufficient, capital controls are cumbersome, and ownership rules via the stock-connect program are unclear. Although this was not the sole reason for the stock slump, it certainly did not help matters when Morgan Stanley also released a pre-market research note predicting a decline in the Shanghai Composite and other analysts followed suit. Fears of overvaluation in the stock market have been confirmed in recent days.
The hype surrounding China’s stock market had mounted in recent months, as news pundits and laymen alike checked in on stock performance with increasing frequency. Millions of individual investors with little experience in the stock market had joined the speculative madness as stories of friends and relatives making large gains in the stock market abounded. The Shanghai Composite Index passed the 5,000 mark for the first time since January 2008 in early June.
The ascent of the stock market followed the bursting of the real estate and shadow banking bubbles in 2014. Some of these funds were channeled into the stock market. The stock market surge was also fuelled by margin loans extended by banks, reaching 2.3 trillion RMB on June 18. Now margin calls are forcing small investors to sell their shares or add more margin to cover their losses. The presence of margin calls has sped up the stock selloff just as rapidly as it accelerated the buying spree. Rules to loosen margin trading and short selling requirements were released for public comment on June 12, but did not end the stock sell-off. These rules allowed for the extension of contract terms beyond the current period of six months.
The Chinese government has viewed the stock market rally as a bubble, which it has attempted to gently deflate. As the market declined, the People’s Bank of China was forced to implement monetary easing policies to prevent a liquidity crunch, cutting the one-year lending rate by 0.25 percentage points to 4.85 percent and reducing some banks’ reserve requirement ratios over the weekend. Easing actions have been dubbed the “Zhou put” by traders who view People’s Bank of China Governor Zhou Xiaochuan’s monetary policy as a way to maintain economic activity. Still, the current stock market downturn has managed to deflate only the last month’s speculative activities; the Shanghai Composite Index is back at May levels, with plenty of room to slide further. How long the “Zhou put” can last, at least in terms of bolstering the stock market, has yet to be seen.
China’s leadership is attempting to continue to reform the financial sector in order to promote a more sophisticated market for financial products. However, the process of opening up slowly continues, while controlling for risk has remained one of the primary policy aims.