Lessons Behind China’s Stock Market Crash

What are the factors that triggered the stock price crash in China’s stock market since 2014? And what can we learn from it?

By Liu Xin, PhD Candidate, School of Accountancy, CUHK Business School

From the end of 2014, the Chinese A-share index soared to a seven-year peak. However, only six months later, when the market realized that China’s economy was slowing down, the bubble quickly burst into a disaster. Later in August, when RMB began its devaluation, the stock price crash went global.

While researchers have extensively explored stock price crash, they focus mainly on the developed countries. As the biggest stock market in developing countries, the A share market is significantly different. Moreover, among the studies about developing countries’ crash, there is less focus on governmental factors, than economic factors that triggered the stock price crash. This blog intends to fill in this gap. Let us first review the Chinese government’s reactions before and during the crash.

Before the Crash

The Chinese government has been excessively promoting the stock market. Back in mid-2014, we can reasonably argue that it was the government who let the bull go in the Chinese stock market. Beijing might have foreseen the bottleneck in the real economy, thus coming up with the SEO reform story and unprecedentedly started to support the stock market. For example, People’s Daily, the Chinese Communist Party’s newspaper, publicly reported that 4,000 index points as merely the start of a bull market.

However, the Chinese government is also the first one to drive the bull out of the market. Specifically, as the leverage unexpectedly amplified the price bubble, the China Securities Regulatory Commission (CSRC) rigorously stepped up to regulate over-the-counter margin financing. Afterwards, the market started to plunge for three more months.

During the Crash

Due to the above regulations which caused unexpected chaos and market overreaction, the government officially undertook various supporting measures to “save the market”, including cutting interest rate, stopping initial public offering, providing cash to brokers to buy shares, limiting short selling, etc. However, these measures had only confused individual investors more. Many individual investors said that they would have exited the market if the government had not been so provocative and optimistic about the rescue.

Therefore, the disaster would have been much less severe if the government had stayed out of the market in the first place. On the one hand, the government threw out the SOE reform dream and encouraged inexperienced investors into the market, rather than admitted the economic difficulty. On the other hand, the government had not control the leverage problem until it became too severe. When it finally decided to solve the problem, there was no consideration on the best solution.

Reflecting on what happened in the crash, here are a few critical questions to ask:

Q1: Why did the Chinese government encourage the reform bull in the first place?

The intention is obvious. China has to make reforms to stimulate the economy which has been slowing down. The stock market is an ideal place to solve SEOs’ financing problems. Besides, if stock prices go up, local governments can sell its SOEs shares to pay its debts. If things go smoothly, the whole economy will be liberalized.

However, the encouragement was way out of line. Before the crash happened, the state sectors mainly focused on cheerleading and neglected systematic problems such as the increasing leverage.

Q2: Why didn’t the government try to solve the leverage problems in a softer manner?

Since there was no sudden shock in the real economy, CSRC underestimated the market sentiment and thought that it could solve the problem in a quick and clean way. Although CSRC has a similar role like the Securities and Exchange Commission (SEC), it works for the government rather than for the Chinese investors.

In an autocratic country such as China, investors have little bargaining power over the authority. CSRC cares mainly for the government where its interest lies. As investors barely have any influence, CSRC seldom put their interests into consideration. Unfortunately, investors, especially the individual ones, have no choice but to bear the consequences.

Q3: Why did the government decide to rescue the market?

Many experts consider the rescue unnecessary, since the influence of this crash on economy is limited. However, the consequence of this crash is so widespread that the government has to save its reputation. Moreover, a successful rescue can allow the SOE reform to continue. With the large debts, excess capacity in heavy industry and a declining workforce, the government has no other options but to carry on the reform.

Q4: Why did the market overreact?

A major reason lies in a systematic deficiency. CSRC sets a daily trading limit with an up/down limit of 10 to all listed shares. With the daily limit, a stock becomes in-transferable when its price falls down by 10 percent. The 10 percent daily limit made the overreaction much longer, because in-transferability causes devaluation. Specifically, when market overreacts to bad news, everyone try to cut their loss by selling their holdings as soon as possible. The rush to sell will inevitably cause overreaction to bad news. Meanwhile, a short-seller can gather shares at the minus 10 percent limit at a much lower cost than usually. The lower cost in turn makes short-selling much more easily in the following day.

Q5: Why was the market rescue unsuccessful?

Of course, there is more than one reason behind the unsuccessful rescue. For example, CSRC never touched the above mentioned deficiencies caused by the trading limit. But here let us focus on a very important political factor.

Indeed, the stock market has become the battlefield between factions inside the Chinese Communist Party. Many actions during the crash were totally inconsistent with the rescue. For example, there were a few times of massive selling of state-affiliated firms.

Speaking to Epoch Tinmes, Wang Jianguo, a professor at the Guanghua School of Management at Peking University, pointed out that “the whole plot is like a sequence of linked rings. It is absolutely not possible to execute a ‘financial coup’ at such an astonishing scale without a perfect plan or knowing the rival’s weakness and ignorance in finance so clearly… Propaganda, financial leverage…collectively going short and the timing to attack have been working together. The extreme deviousness of one faction and the arrogance of the other faction synchronizes to make what we see happen.”

Therefore, it is likely that Jiang Zemin’s faction started the crash to attack Xi Jinping’s faction, who has been crippling Jiang’s power over the last two years. Xi’s faction will undoubtedly suffer at least reputational loss from this crash. The recent punishments against some top politicians, accused of maliciously manipulating the market, seems to support this factional battle argument.

The Lessons from the Crash

Although the craziness seems to be drifting away from A-share market, we should at least learn the following lessons.

The stock market should be left on its own. No matter how powerful it is, the government should realize that it can hardly control the market. Frequent interventions will only distort the market. Intervention can fail not only because of market sentiments but also due to factional battles.

The crash proves that the Chinese government indeed has the incentive to withhold bad news, which has been evidenced among academics. The severity of leverage problem has stayed outside the public attention until it cannot be hidden any longer. Therefore, investors, especially individual investors, who are the last to know the news and have little bargaining power, should always be cautious about some unrevealed bad news.

The rescue measures during this crash have not fixed the systematic deficiency. The Chinese stock market remains opaque and controlled by the government. It should be of no surprise if this kind of crash will happen again in future.

References:

王若宇. “4000点才是A股牛市的开端”. People.com.cn. April 21, 2015.

Kenneth Rapoza. “A Timeline of What China’s Gov’t Did to Save Stock Market”. Forbes.com . July 13, 2015.

Alchian, A., (1965), “Some Economics of Property Rights,” Il Politico 30, 816-829.

Manzetti, Luigi. “Political manipulations and market reforms failures.”World Politics55.03 (2003): 315-360.

Piotroski, Joseph D., T. J. Wong, and Tianyu Zhang. “Political incentives to suppress negative information: evidence from Chinese listed firms.”Journal of Accounting Research53.2 (2015): 405-459.

Robertson, Matthew. “Was the China Stock Market Crash Engineered?” Epoch Times. July 23, 2015.

Elliott, Larry. “China stock market panic shows what happens when stimulants wear off.” The Guardian. August 24, 2015.