How does the market volatility in China affect you? Stock prices in China have plummeted over the past few weeks. This turmoil has raised concerns regarding the outlook for the world’s second-largest economy and potential spillover effects on global markets.
The Cause
China’s stock market has displayed many characteristics of a bubble. The Shanghai Composite Index is the Chinese market’s primary benchmark, similar to the S&P 500 here in the U.S. From July 2014 to June 2015, the Shanghai index more than doubled. During this time, millions of brokerage accounts were opened by working-class Chinese investors looking to cash in on the rally. Teenagers, grandmothers, and everyone in between were all making small fortunes by joining the party. These retail investors have driven prices up by participating in this frenzy of “chao gu” or stir frying stocks --- Chinese slang for trading.
The concern with this rally is that it happened without an accompanying rise in earnings or economic growth. And, it’s hard to see anything in China’s economic conditions or policies that would justify this kind of remarkable increase in share prices. Another important factor in this mass-inflow is that a large portion of it was purchased “on margin” --- that is, with borrowed money.
When you buy a stock on margin, you are essentially taking a loan to fund the purchase. The stock you purchase then becomes collateral for the loan. This can be very beneficial to the investor if stocks go up, but can also produce instability in the market when prices fall. If the stock market starts to fall, brokers will ask margin borrowers to put up more collateral for their loan. If the investor can’t provide cash, then the broker will begin to sell shares in the borrower’s account to pay down the loan. These sell-offs can trigger further declines in the market, which can trigger more margin calls, and, consequently, more sell-offs. It becomes a vicious cycle.
Why did this rally happen? When you put all the pieces together, you have a rise in share prices driven more by investor psychology than by anything fundamental. It becomes increasingly difficult to justify the peak prices seen in early June and increasingly easy to see why the sell-off of late June into July occurred.
The Implications
Few non-Chinese investors have direct exposure to China’s stock markets due to government limits on outside investment. Therefore, most victims of the decline are Chinese citizens. Unlike U.S. stock markets which are largely driven by institutional investors such as mutual funds, the Chinese stock market is mostly driven by its citizens, i.e. “retail investors”.
One concern is that since the stock market rout has left millions of China’s citizens with losses in their accounts, they will be much less likely to spend money. Given the country’s already slowed economic growth, a significant decrease in consumption could create further risks for the economy and financial system.
The drop in China’s stock market has rattled stock exchanges elsewhere, mostly in other Asian countries, but hasn’t had a major effect on U.S. stock markets. That is not to say, however, that we won’t experience a ripple effect in our economy. If China’s economic engine sputters further, this could cause problems. Specifically, U.S. exports to China as well as U.S. based companies with a large presence in China could suffer. If Chinese demand decreases as a result of less spending by their consumers, then U.S.-based companies that rely on Chinese revenues could have a challenging road ahead.
The Solution?
While some believe that China’s stock market is undergoing a much needed “correction,” their government is throwing the kitchen sink at the problem. They are enacting multiple corrective measures such as cutting interest rates, using government pension funds to prop up the market, suspending new share listings, forbidding some investors from selling, and even criminally prosecuting short sellers. Just as investor psychology provided fuel for the sharp increase, it can also provide fuel for a sharp decrease. This will be especially true if Chinese retail investors show signs of panic and run for the exits. As the Chinese government strives to revive confidence in the market and support for stock prices, we can only hope that a solution is reached that mitigates the losses for China’s consumers.
Summary
While this heightened volatility in China’s stock market may not have direct effects on U.S. investors, it is important to be aware of the global economic landscape and world events such as this. We know that globalization has many benefits, but it also makes it very difficult, if not impossible, to completely insulate an investment portfolio from worldwide shocks.