China’s stock market crash explained

The world was in utter shock when stock prices across the globe crashed in an unprecedented manner on Monday 24, August 2015 in response to the steep crash in Chinese stock prices. In China, the main stock index -the Shanghai Composite Index has fallen by almost 9% on Monday. The Chinese stock market is in crash mode since June this year, reversing the previous one year's sharp rise.

From Japan to US, stock prices in non-Chinese markets fell between 4% to 6% on an average; producing one more ‘black Monday’ in stock markets.

Early trends for Tuesday (25th August) indicates that share prices continues to nose down; both in Japan and China where trade begins early.

Many economists and experts are predicting that the Chinese stock crash will deepen the present recession and the world economy is entering into another crisis phase since 2007. Some experts have compared the Chinese stock burst to the US stock crash in 1929, which ultimately brought the Great Depression.

Now, what is the real problem in China?

What is China’s stock market crash?

To understand China’s present stock market problem, we have to know that the Chinese stock prices have peaked or was very high during June 2015. For the Shanghai Composite Index this is the peak recorded after the crisis of 2008.

The Shanghai Composite Index (SCI) recorded the seven year highest point of 5220 on June 23, 2015, but scooped down to 3209 on August 24th. Share prices were falling during the last two months despite several measures by the Chinese authorities.

Since June, the Chinese stocks are undergoing a free fall. Following facts will reveal the extent of the market crash.

  • The biggest monthly loss in six years was recorded during July 2015.
  • The biggest daily loss in nine years was recorded on 24th of August (nearly 9%).
  • In two trading days (21st, 24th of August 2015), the Chinese share prices were fallen by 13.2%.
  • If we add the trading trend of Tuesday (25), the SCI has crashed by 20.5% in the last three trading days.

Understanding the bubble and burst in the Chinese market

Your learning about stock market should start from an important lesson. The lesson is that every bubble will end in a burst. In the stock market, bubble is shaprt rise in prices of shares. Burst means deep fall in prices or a crash. If share prices have registered a sharp increase or bubble, the high probability for the coming period is for a steep fall and not further rise. Simply put, for every bubble, there will be a burst.

For China, the stock market was forming a bubble between June 2014 and June 2015. In this one year period, the stock prices increased by 150%. The SCI was just 2050 in June 2014 and it sky rocketed to 5220 in June 2015.

Following trends indicate the bubble and burst episode in SCI.

Time Shanghai Composite Index points

June 2014 – 2050 points

Dec 2014 - 3200 "

June 23, 2015 - 5220 "

April 24, 2015- 3209 "

So clearly, there was a bubble formation and a burst was in the making.

What contributed to the bubble in China’s stock market?

The Key point to solve this problem is that China’s stock prices have increased by 150% in one year between June 2014 and June 2015. This increase is an unprecedented one given the slow growth in the economy. Besides, the world economy is in recession.

The main reason for the share price was the policy of the government to encourage participation of general public in stock market. Banking system was encouraged to allow people to borrow money and purchase shares.

In the one year period between June 2014 and June 2105, nearly 40 million new accounts were made. Most of the new share purchasers were made by ordinary people. It’s reported that the highest monthly account opening of 9000000 was in October 2014. Nearly ten million new share buyers joining the trading is a phenomenal event.

Another factor that boosted stock market trading volume was promotion of margin trading by public. Margin trading allows people to trade huge volume of shares with small amount of money in thier account.

Why stock prices have fallen?

The basic reason for the continuous fall in stock prices is the declining growth trend in the Chinese economy. Slowing economic growth and exports fall and declining investment spending and profit scenario of companies- all were negative news.

Slowing growth rate is a negative news and in China such a negative news came at a time when the market is already at an unbearable high level or what we can say, at the peak of the bubble.

Slowing growth means less prospects for companies in future. In this scenario, the public who invested in equities found the present stock prices very high, triggering motivation to sell shares. Besides, policy maker’s inability to rescue the market has shocked the investors who later sold shares to save their money.

Hence, people responded by aggressive selling of shares. Later during July and August, people made panic selling fearing losses. It is to be noted that ordinary public sells quickly, but institutional investor will not sell that quickly. There was high participation of individual investors in Chinese equity markets.

In conclusion, it can be said that the present crisis in Chinese stock market is a steep correction. Already stock prices were increased by 150% due to buying pressures. That may be corrected through price fall. The price fall of course is triggered by slowing economy news.

What will be the impact of Chinese stock market crash on India?

The imact of the Chinese stock crash is going to be slightly mixed in India. This is because, though India is increasingly depended upon foriegn investment in stock market, the economy is stabler among the EMEs. Besides, traditionally India is slow in quick reforms and this has rescued India in all previous global crisis- the Mexican crisis, the East Asian crisis and the global financial crisis of 2007.

This time also weak policies in China may put a vote of confidence on India. This doesn't mean that flucutation in global markets is going to be unaffected. Stock prices and value of rupee all will be influenced by Chinese events, but in a moderate manner.

India is stabler among the EMEs

India at present is the most stable among the EMEs and the fastest growing in the recession hit global economy. Fall in commodity prices will help us more rather than hitting us. Hence, though the adverse effect from China's economic problem will be univesral, it will be less severe on India.

The adverse effects and thier probabililties

There will be two effects of the Chinese rout on India's economy. First is the stock market panic, fall in stock prices and depreciation of rupee. Nearly 30 percent of active traders in India's stock market are Foriegn Portfolio Investors (FPI). Now these group may continue to sell shares in immediate future ot from panic in the global markets. Each time the global market comes under turmoil, it will bring simiar effects in India as well.

Depreciation pressure on Rupee

Similarly, both India and China are taged as Emerging Market Economies. Lack of trust in Chinese economic management may create corresoponding effect in India as well, but in the short run only. A capital flight or what we often say, contagion effect may set in at least in the short run. This will prodcue capital outflow from India's stock market and the economy. The outcome of such a capital outflow will be depreciation of rupee. The extent of stock fall and rupee depreciation depends upon how quickly the Chinese stock fall is arrested.

GDP growth and economic performance

Secondly, GDP growth will decline in the long run as a result of capital outflow and uncertainty in global markets. Sharp decline in exports, investment etc are some adverse effects of the Chinese rout.